Refinancing America : The Republican Antitax Agenda [1 ed.] 9780791487549, 9780791455890

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Refinancing America

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Refinancing America The Republican Antitax Agenda

Sheldon D. Pollack

State University of New York Press

Published by State University of New York Press, Albany  2003 State University of New York All rights reserved Printed in the United States of America No part of this book may be used or reproduced in any manner whatsoever without written permission. No part of this book may be stored in a retrieval system or transmitted in any form or by any means including electronic, electrostatic, magnetic tape, mechanical, photocopying, recording, or otherwise without the prior permission in writing of the publisher. For information, address State University of New York Press, 90 State Street, Suite 700, Albany, NY 12207 Production by Dana Foote Marketing by Patrick Durocher Library of Congress Cataloging-in-Publication Data Pollack, Sheldon David. Refinancing America : the Republican antitax agenda / Sheldon D. Pollack. p. cm. Includes bibliographical references and index. ISBN 0–7914–5589–0 (alk. paper) — ISBN 0–7914 –5590– 4 (pbk. : alk. paper) 1. Taxation—United States—History. 2. Income tax—United States—History. 3. Republican Party (U.S. : 1854 – ) 4. United States—Politics and government. I. Title. HJ2381 .P65 2003 336.2′00973—dc21

10 9 8 7 6 5 4 3 2 1

2002030593

For Patti L. Werther

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Contents ix

Preface

xiii

Acknowledgments Introduction

1

1

The Origins of Republican Tax Policy

19

2

Forever a Minority Party?

35

3

Reagan Changes the Course

57

4

The Tax Deadlock Decade

71

5

Tax Policy in the Twenty-first Century

107

6

GOP Campaign to Kill the “Death Tax”

137

7

The Great Corporate Tax Giveaway

159

8

The Politics of the Surplus

169

Conclusion:

The Prospects for U.S. Tax Policy

199

Appendix 1: Charts

205

Appendix 2: Tables

211

Notes

227

Bibliography

267

Index

271

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Preface The subject of this book is the Republican party’s long-time obsession with tax cuts. This obsession has been expressed in the countless proposals for tax cuts introduced by Republicans in Congress during past decades, as well as the successful campaign by the administration of President George W. Bush for a $1.35 trillion tax cut. Since the 1920s, regardless of whether the country is in recession or anticipating trillion-dollar budget surpluses, Republicans have prescribed tax cuts as the panacea for whatever ails the nation. My own obsession with federal tax policy began in 1986 when I left the quiet world of the academy and entered the tumultuous world of the legal profession to practice tax law. Ironically, that was the same year Congress decided to rewrite the tax code pursuant to the Tax Reform Act of 1986. It proved a difficult, yet fascinating time to enter the profession. With Congress making so much new law, tax professionals were thrown into a tizzy trying to keep up with the multitude of changes. The rest of the decade proved no less exhausting for tax professionals, as Congress kept up the pace, churning out massive tax bills every year or two and using the federal tax code to implement a wide range of public policies and social programs, as well as to achieve numerous political goals. This overtly political use of the tax laws has rendered the income tax a very complicated body of law and turned the practice of tax law into an arduous enterprise. To be sure, practicing tax law has its benefits—most specifically, financial. In addition, there is some satisfaction to be had in deciphering the complicated problems that commonly arise under the tax laws. However, I soon found that the study of tax policy (as opposed to the practice of tax law) offered greater personal satisfaction, and so I eventually returned to the academy to pursue scholarly interests. Since then, thanks to the many opportunities and freedoms afforded by academic life, I have devoted much of my time to studying the politics and limitations of contemporary tax policymaking. This, along with teaching my students some of the basics of business and tax law, has provided a rewarding alternative to private legal practice. My studies ultimately culminated in the publication of The Failure of U.S. Tax Policy: Revenue and Politics in October 1996. That book was a critical assessment of the political process that produces the income tax laws of the United States, with special focus on developments in tax policy during the 1980s. With respect to the latter, the conclusion was that U.S. tax policy in the 1980s was ix

Preface “erratic,” “unstable and internally inconsistent,” “extraordinarily complex,” and “highly partisan.” It turned out that in assessing how unsettled tax policy had become in the 1980s, I did not realize how bad things could get. Indeed, things got considerably worse in the 1990s. In the 1990s, the politics of the income tax became even more contentious, erratic, partisan, and at times, downright vicious. With its unexpected victory in the 1994 congressional elections, the Republican party took control of both houses of Congress for the first time in forty years. However, the White House remained occupied by a Democrat, William Jefferson Clinton. The result was divided government, and most of the time, political deadlock over tax policy for the rest of the decade. House Republicans were fixated on reducing taxes, but the major tax-reduction legislation that they passed was invariably unpalatable to the Democrat in the White House. Many times even their own more moderate Republican compatriots in the Senate opposed their antitax policies. But in the end, it was Bill Clinton who thwarted the most aggressive antitax Republicans in the House of Representatives. Throughout his eight-year tenure in office, Clinton repeatedly vetoed Republican tax reduction proposals, and the Republican leadership of the House repeatedly proposed new tax cuts. Tax legislation was occasionally enacted into law in the 1990s, but it was never what the antitax Republicans really wanted. Nor was it indicative of what policies Democrats would have enacted if given the opportunity. On the other hand, the tax code was in many ways better off for divided government. The level of acrimony and partisanship increased as the decade wore on. The high point of partisan combat was the impeachment of the Democratic president by the Republican House. Notwithstanding this bold exercise in legislative authority, Clinton remained in office and continued to block Republican efforts to cut taxes for the rest of his term. Throughout the balance of the decade, the antitax wing of the Republican party defined the terms of the debate and set the tax policy agenda in Congress. However because of President Clinton’s persistent use of the veto power, Republicans were unable to carry out any of their numerous attempts to slash taxes. I finished writing my first account of contemporary tax policymaking, The Failure of U.S. Tax Policy, just as Republicans took control of Congress in January 1995. As it turned out, that was before the most intense political battles between the Clinton administration and the Republican Congress. Because things really got interesting in the years after the Republicans came to power in Congress, I decided to continue the story. In this respect, this book is a chronicle and assessment of Republican tax policy mainly because Republicans dominated the tax policymaking process during the 1990s. Furthermore, tax policy itself dominated the broader political agenda during this period. As such, this story reveals a good deal about contemporary American politics. I begin the study with a historical review of Republican tax and economic policy from the founding of the party in 1854 through the Democratic-dominated x

Preface period of the New Deal of the 1930s. The Republican party went through significant changes at the close of the nineteenth century and then again during the 1930s. During the latter period, Democrats completely dominated tax policy and Washington politics in general. The Republican party of the late nineteenth century found itself in retreat during the 1930s, and Republicans contributed little to the debate over tax policy. Mostly, Republicans asserted some measure of opposition to the prevailing Democratic policies, expressing their own marked preference for lower tax rates. After World War II, a resurgent Republican party began to play a more active role in shaping tax policy. At the same time, a conservative antitax faction emerged within the Republican party itself and took control of the party apparatus by the mid-1940s. After numerous setbacks and defeats over the next half century, the antitax faction enjoyed an unexpected resurrection in 1994 when Republicans won control of Congress for the first time in forty years. This reinvigorated Republican party and the antitax faction that came to dominate the party (especially among House Republicans) is the central focus of this study. Rather than looking at the political and legislative process through which tax policy is made, the emphasis here is on the Republican campaign for “fundamental tax reform”—the code phrase used by Republican candidates in the 1990s looking to repeal or severely reduce federal taxes. The Republicans who came to Washington in the freshman class of 1995 were generally more conservative and dedicated in their opposition to federal taxation than prior generations of Republican legislators. The new breed of conservative antitax Republicans were strongest in the House, where they continue to dominate. This book outlines the modern Republican agenda with respect to federal taxation—or more precisely, the party’s devoted opposition to the federal income tax. The election of George W. Bush as President in 2000, along with the slight edge that Republicans retained in both houses of Congress immediately following the election, seemed to signal that the Republican antitax message would continue to resonate for years to come. Bush’s election gave hope to Republicans that the partisan deadlock between Democrats and Republicans would finally be resolved to the advantage of antitax conservatives. The emergence of this new Republican dominance in Washington was very much evidenced in May 2001, when the 107th Congress passed the first major tax-reduction bill in twenty years, the Economic Growth and Tax Relief Reconciliation Act of 2001. President Bush enthusiastically signed the measure into law. However, the Republican hold on the tax policymaking process turned out to be tenuous and short-lived, as did predictions of significant budget surpluses for the federal government. Democrats fortuitously regained control of the Senate immediately following enactment of the 2001 tax act when a single Republican Senator switched parties, and the future of the antitax wing of the Republican party became a whole lot more uncertain. The extent to which their antitax message will prevail even within the Republican party itself is now unclear. Of course, the antitax wing of the Republican party has xi

Preface suffered setbacks before, and it is not likely to go quietly from the political stage. Likewise, the power and longevity of its message should not be underestimated. There is a strong and powerful constituency for the Republican program of tax cuts that will persist. The story of Republican antitax politics is hardly over, even if this particular chapter has drawn to its conclusion.

xii

Acknowledgments A great many people assisted me in this project. In particular, I wish to thank Youssef Cohen of New York University, Paul Quirk of the University of Illinois, Larry Seidman of the University of Delaware, Jay Soled of Rutgers University, Ronald King of Tulane University, and Irving Louis Horowitz of Rutgers University. Each read portions of the manuscript and offered valuable suggestions about how the text could be improved. Also, my editors, Michael Rinella, Dana Foote, and Saralyn Fosnight, as well as the four anonymous readers for the State University of New York Press offered helpful comments and criticisms that greatly improved the book. At the University of Delaware, Gail Ross, and my research assistant, Stefanie Waters, provided assistance in preparing the manuscript for this book. Both the Irving Louis Horowitz Foundation for Social Policy and the Department of Accounting of the University of Delaware provided generous financial support. The research librarians at the Van Pelt Library of the University of Pennsylvania and the Morris Library of the University of Delaware helped me in tracking down hard-to-find documents and books. I thank them for their assistance. I spent the summer of 2000 as a guest of the Urban Institute in Washington, D.C. Gene Steuerle was generous in arranging the position, which allowed me to make use of the Urban Institute’s excellent facilities and resources. I appreciate the opportunity, as well as the hospitality shown to me by the staff of the Urban Institute during my visit. Finally, I thank my family for their constant support. I am particularly grateful to my children, Alyssa and Seth, for their love and affection. Without them, I never would have had the incentive or drive to even begin, let alone to complete, such a time-consuming undertaking. Mercifully, they stayed off my computer long enough to allow me to finish this book. My deepest debt of gratitude is to my wife, Patti Werther. She supported me during this and other projects, and has never once (well, seldom) questioned my many follies and detours. This book is dedicated to her. Refinancing America draws freely upon ideas, arguments, and material that I developed over the years and originally presented elsewhere. In chapters 1 and 2, I rework and refine some of my own accounts and interpretations of contemporary federal tax policy that first appeared in The Failure of U.S. Tax Policy: Revenue and Politics (University Park: Penn State Press, 1996). For many years, I have used the professional journal Tax Notes as a forum for expressing my ideas xiii

Acknowledgments about tax policy. Christopher Bergin and Robert Wells of Tax Notes have provided me with the opportunity to publish there, and I thank them. A version of the introduction first appeared as “Republican Antitax Politics” in the 9 April 2001 issue of Tax Notes. Chapter 4 is based on “Tax Policy in the 1990s: On the Road to Nowhere,” which appeared in the 27 December 1999 issue of Tax Notes, while Chapter 9 is derived from “PAYGO and the Politics of the Surplus,” which appeared in the 15 February 1999 issue of Tax Notes. I originally wrote about Republican efforts to repeal the federal estate and gift tax in “It’s Alive: The GOP’s Plan to End the Estate Tax,” which appeared in The American Prospect (31 July 2000). I previously wrote on the Republican proposal for a “flat tax” in The New Republic (18 & 25 September 1995) and on corporate tax shelters in Legal Affairs. I am grateful to the editors and staff of all of these publications for their support and assistance.

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Introduction No Capitation, or other direct, tax shall be laid, unless in Proportion to the Census. —Article I, Section 9 of the U.S. Constitution (1787) Congress shall have the power to lay and collect taxes on income, from whatever source derived. . . . —Sixteenth Amendment to the U.S. Constitution (1913)

During the 1980s, tax policy emerged as one of the most prominent issues on the agenda of the Republican party. In the 1990s, tax policy (or more properly, “antitax” policy, by which I mean a public policy of opposition to federal taxation) became the outright obsession of the Grand Old Party.1 If anything, the infatuation is even stronger today, following the successful Republican campaign for major tax reduction in 2001. How did it come about that the core issue, the apparent riason d’ˆetre of the Republican party, became something so mundane as reducing taxes? The “party of Lincoln,” once dedicated to Liberty, the Constitution, preserving the Union, abolishing slavery, and other grand principles of national government, committed itself to nothing more inspiring than cutting taxes. Of course, there are times when reducing the tax burden of the citizenry is the appropriate and prudent course of action. Furthermore, Democrats in Congress and the White House have repeatedly increased the tax burden on the wealthy whenever they have had the chance, leaving it to Republicans to push in the opposite direction. Nevertheless, it must be asked even by those within the Republican fold whether a program of tax cuts really makes for a domestic policy agenda worthy of a major national political party? In the 1990s, the conservative leadership of the Republican party consciously and intentionally placed tax cuts at the top of the party’s policy agenda. Throughout the decade, the GOP displayed a fixation on tax cuts nearly to the exclusion of all other concerns. The many other familiar themes of Republican candidates from the 1950s, 1960s, and 1970s (opposition to the Communist bloc, “law and order,” hostility to the “liberal” policies of the U.S. Supreme Court) faded into oblivion as the antitax 1

Introduction message took hold of the party. Ironically, notwithstanding this commitment to the antitax liturgy, the GOP was neither successful in enacting a major tax cut in the 1990s nor in exciting the electorate with its antitax message.2 As both a legislative program and an electoral strategy, the antitax message played distinctly off-key to a good portion of the electorate. Yet the band played on, repeating the same tune over and over throughout the 1990s. It was not until May 2001 that the GOP finally succeeded in enacting a major tax cut—the first in twenty years. The question of how and why the Republican party (led by its conservative wing) became fixated on tax policy is the central concern of this book. Of course, this focus leaves out a good deal about contemporary U.S. tax policy, which reflects much more than just the dynamics of the party system. The income tax is used for a wide variety of purposes. The diverse, and often conflicting, uses of the income tax by politicians and state officials was the subject of my previous study of federal tax policy.3 Most important, the income tax serves an important revenue function. The income tax is used by state officials as one of the principal means of raising the vast sums required to finance the activities of the modern American state. The individual income tax alone now raises over $1 trillion annually, and the individual and corporate income taxes collectively raise about 55 percent of the total revenue of the federal government. Beyond this revenue function, the income tax is used by officials as an instrument for making social policy. It also is used to implement national economic policy. Finally, the tax code is commonly employed by elected politicians as a nonpartisan tool for constituency service. Republicans and Democrats alike use the tax laws to shelter, and in many cases, bestow favors upon constituents and powerful economic interests in their home states and districts. As I argued in my previous study, this nonpartisan use of the income tax is most directly at odds with its use as a tool for raising revenue and directing national economic policy, and generally distorts and undermines the coherence and integrity of U.S. tax policy. On top of these uses of the federal income tax, the two major political parties have long employed the income tax as a means for expressing and implementing their respective partisan policies and programs. Such an overtly political use of the income tax became especially prevalent among Republicans during the past twenty years as partisanship played an increasingly important role in directing federal tax policy. The substantive arguments for and against these contemporary Republican tax policies are examined herein, as are the merits and shortcomings of the various proposals introduced, as well as the tax legislation actually enacted during those periods when the GOP controlled the legislative process. This includes the 1920s, the second half of the 1940s, the early 1970s, and the 1980s. However, compared to these other periods of Republican predominance, Republican antitax policy was much more extreme in the 1990s. This more extreme expression is the subject of this book. Of course, Democrats controlled Congress and the White House for much of the postwar period, and hence 2

Introduction Democratic tax proposals also must be considered. Republican tax policy typically needs to be explained in reference to what the Democrats are doing. For example, the Democratic tax legislation enacted in 1993 was perhaps the most partisan tax bill in fifty years. This provoked the strong Republican counteroffensive that began in 1994. Aside from the need to respond to Democratic initiatives, what is the driving force behind contemporary Republican tax policy? Most important is the idea! Republicans committed to tax cuts, as well as the outright elimination of a number of federal taxes, not so much as an instrumental or strategic political issue for winning elections (which they did to some degree), but as an article of faith. Such an ideological commitment seldom arises out of thin air, but rather typically emerges out of the rooted traditions and history of a political party. There is a basic continuity in the ideology of any political party—even in the conspicuously pragmatic, nonideological, nonpolicy-oriented parties of the United States. New ideas may come and go, but there are underlying principles that hold a party together over time. Political parties in the United States are not merely coalitions of convenience that come together for a particular election, and then melt away, only to reform on some other principles for the next election— although the national party organizations in the United States are that to a great extent. Certainly, the Republican party in 2001 is not the same political party as the Republican party of 1854. That party was transformed dramatically in the 1890s and 1930s within the context of broad shifts of the electorate and fundamental changes in the party system. However, there is nonetheless a consistency in doctrine and interests that underlies the Republican party throughout its long history—certainly with respect to tax policy. In the chapters that follow, I trace the origins and remarkable consistency in Republican doctrine with respect to tax policy. Antitax sentiments have always run strong within the GOP, although Republicans have historically tolerated, and even supported, regressive excise taxes such as the tariff. More to the point, conservative elements within the Republican party have resolutely opposed the taxation of income and wealth. This sentiment was manifest when the first federal income tax was adopted in 1861 during the Civil War, when an inheritance tax was added in 1862, again when the income tax (which previously had expired in 1872) was reenacted in 1894 by a Democratic Congress, and finally when the modern versions of the income tax and estate tax were enacted in 1913 and 1916, respectively. In the 1920s, conservative Republicans successfully pursued a campaign to reduce income taxes. In other words, hostility to income and wealth transfer taxation has permeated the Republican party virtually since its inception. So the antitax policies of the GOP in the 1990s certainly were no aberration. Nevertheless, there was something unique and extreme in the party’s rhetoric and devotion to the antitax cause in the closing decade of the twentieth century. It is this more dedicated (dare I say, fanatical) strain of antitax politics, its numerous manifesta3

Introduction tions, and how it came to dominate the modern Republican party, that is the focus of this study. At the beginning of the twentieth century, the credo of the Republican party reflected its long-standing commitment to limited government (antistatism) and resolute opposition to nineteenth century Populism and egalitarianism. By the 1920s, hostility to income taxation was also well entrenched within the GOP, and tax cuts became central to Republican economic policy. These were the bread-and-butter issues of Republicans that served them well for decades. However, there was a marked transformation of Republican thought, as well as the party itself, during the New Deal of the 1930s. At that time, the party that had dominated national politics for decades (and in the matter of course, controlled the direction of federal tax policy) was suddenly overwhelmed by the new Democratic majority and reduced to perennial minority status. The Republican party, on the defensive since the 1930s, became a permanent opposition party— generally in opposition to the new administrative state created during the New Deal, and in particular, to New Deal tax policy. The other side of Republican enmity toward a strong central government in Washington is a deep and abiding faith in the virtues of state and local government. This is often expressed in the form of high-minded praise for federalism. At times, Republican exuberance for federalism (which ironically, at times more closely resembles the states’ rights perspective of the Anti-federalists of the 1780s) amounts to nothing less than a utopian effort to resurrect state-federal relations of the late nineteenth century— a return to the Gilded Age of the 1880s, as if the New Deal and the nationalization of American political institutions had never occurred. After World War II, the traditional credo of the GOP expanded to embrace the virulent anticommunism that came to grip the Right Wing of the Republican party. In the 1920s and 1930s, strong antagonism toward communism was commonplace in the Republican party. With the onset of the Cold War following World War II, the anticommunism of the Right Wing overwhelmed the party. True, McCarthy was an extremist and not necessarily indicative of the sensibilities of most Republicans. However, he did both reflect and influence the direction of the party’s thinking. In the postwar decades, the Republican party adhered to this dual commitment to anticommunism, which dominated the party’s thinking on foreign policy, and the curious blend of antistatism and states’ rights, which pervaded Republican thinking on domestic policy issues. Antitax sentiment was just one more expression of the latter. Things changed dramatically by the end of the 1980s. With the collapse of the Soviet Union and its empire in Eastern Europe, the anticommunism that held sway over the Right Wing of the Republican party weakened. Soon the enemy barely existed, and anticommunism was a minor force within the party. At the same time, the antistatism of right-wing Republicanism was losing its hold on the party, and even when asserted by traditional conservatives, proved largely impotent. After all, Richard Nixon had declared himself (and by implica4

Introduction tion, every other Republican) a “Keynesian” willing to use the powers of the American state to regulate the national economy, and Ronald Reagan, the most successful and aggressive conservative president in fifty years, had failed to reduce the size of “Big Government” in Washington during his two terms in office. Reagan had boldly proposed abolishing several cabinet level departments—most prominently, the Departments of Energy and Education. But today, long after Reagan has left office, these and a host of other clientele agencies flourish in Washington as a veritable tribute to the resiliency of the modern bureaucratic interest-group state. After Reagan, the very idea of dismantling the post–New Deal state no longer seemed feasible, or what is more important, even desirable to most mainstream Republicans. As journalist David Brooks has lamented in the conservative magazine, The Weekly Standard: “Sometimes you get the impression that today’s Republicans have ended up ratifying the Great Society programs exactly as the Eisenhower Republicans ratified the New Deal.”4 Today, Republicans use the state apparatus to preserve and protect their interests and constituents, as opposed to those of the Democrats. Case in point: One of the first official acts of George W. Bush, the self-proclaimed “compassionate conservative,” was to create (not dismantle) a new government agency—the White House Office of FaithBased and Community Initiatives. Apparently, even voluntary charitable and religious organizations now need to be funded and organized through their own government agency under the direction of the Republican administration. Likewise, as energy shortages persisted in California throughout the spring of 2001, the secretary of the Energy Department in the Bush administration, former Republican Senator Spencer Abraham, pushed for a new coordinated national energy policy. Central planning and an intricate system of tax credits were now touted by a conservative Republican administration as the solution to market fluctuations caused by the deregulation of electric power utilities in the Golden State.5 Such developments have forced those on the Right to accept the limited possibilities for reducing the size and scope of the federal government. William F. Buckley, one of the most thoughtful conservatives of the past fifty years, now admonishes his fellow conservatives to recognize “that certain fights we have waged are, quite simply, lost.”6 Intellectually honest conservatives must recognize that the New Deal is over, but concede that New Deal institutions are now more deeply entrenched in the American regime than ever, and Big Government in Washington quite simply cannot be abolished. By the 1990s, the two most fundamental principles of postwar American conservatism no longer moved the Republican party faithful. The ideology of the Republican party narrowed in the early 1990s as anticommunism became a moot issue and antistatism a lost cause. What was left? While so-called New Right social conservatives devoted themselves to their activist “pro-life” (i.e., antiabortion), pro-family agenda, the old fashioned Right Wing of the Republican party concentrated its efforts on repealing a good deal of the tax system that supports 5

Introduction the national government in Washington. Hostility to federal taxes first became a substitute for dismantling the post–New Deal state, and then it became an end in itself. Antitax politics became the driving force of the Right Wing of the GOP, and the Right Wing itself came to dominate the Republican party. This was as much due to a shift in demographics as anything else, as the voting strength and party base of the GOP shifted from its traditional strongholds in the Northeast and Midwest to the nation’s new booming regions in the West and Southwest. This is now the stronghold of the “new” conservative Republican party. If cutting taxes was a recurring and omnipresent theme in the Republican creed of prior decades, the conservative Republican party of the 1990s committed itself wholeheartedly to the antitax agenda. From a purely rational (“Downsian”) perspective, the commitment of the leadership of the Republican party to an agenda of tax cuts makes perfect sense if the issue can be exploited for advantage in electoral contests. In his 1942 classic, Party Government, political scientist E. E. Schattschneider defined a political party as “first of all, an organized attempt to get power.” Schattschneider associated political power with “control of the government.”7 It should be added as a corollary that in the United States, it is only through elections that political parties can achieve legitimate (albeit temporary) “control” of the government. The Republican party is such an association organized around the goal of winning elections to take temporary control of the government. Certainly, that was the intention of the founders of the Republican party who came together in 1854, and nothing has changed since then. The reason that the GOP or any other political party seeks to win elections is that there are significant benefits to be derived from so controlling the government. This involves more than just patronage, although patronage is still a very important part of the equation. Winning an election also means that the victor gets to govern—or more accurately, attempt to govern—and that generally means imposing one’s principles, whether grand or mundane, on the nation. Of course, things are never so simple in politics. Seldom, if ever, does a political party in the United States really succeed in imposing its will on the nation. The Roosevelt faction of the Democratic party in the 1930s perhaps came closest of any American political party to achieving that end. But the majority party does typically set the agenda, and thereby influence the direction of public policymaking—certainly, more so than the losing party. In short, if a political party’s goals include the exercise of power (and not all partys have that as a goal—witness most third parties), then winning elections is an absolute necessity. And winning elections, as opposed to merely contesting them, requires strategic and instrumental calculations, as well as many compromises regarding the party’s campaign issues. The issues on which a party campaigns (as opposed to official party platforms) must do more than just express the values of the party leadership. They also must express a reasoned calculus for a winning electoral

6

Introduction strategy—which means appealing not only to party elites and activists, but also to a majority (or plurality, as it may be) of the voters. So the question is, Can the deep-rooted commitment of Republican activists to an antitax agenda be viewed as a rational electoral strategy? Does this commitment make sense from the perspective of winning elections and bringing the party to power? Is an extensive program of tax cuts really a rational strategy for a minority party that was dominated for decades by a liberal, populist Democratic party that itself successfully pursued for many years a campaign platform favoring a progressive income tax directed at the wealthy supporters of the Republican party? Or has the ideology of the leaders of the Republican party clouded their vision, impairing their ability to devise a winning electoral strategy, thereby sacrificing electoral victories for principle? To a large extent, the answers to these questions lie in the unique history of the Republican party and the degree of success of its antitax message in actually winning elections and lowering taxes. From this perspective, Republicans have had their work cut out for them from the start. After all, cutting taxes (especially at the margin) almost inevitably benefits the wealthy few much more than the great majority of the electorate, which is comprised mainly of the middle and working classes. This is because in the United States the wealthy pay most of the income taxes collected by the federal government. For instance, in 1999 (the most recent year for which statistics are available) the wealthiest 1 percent of taxpayers (those with adjusted gross income in excess of $293,415) contributed over 36 percent of revenue raised under the individual income tax—which first topped $1 trillion in 2000. The wealthiest 5 percent (those with AGI over $120,846) contributed over 55 percent, and the top 50 percent contributed a whooping 96 percent.8 The flip side is that the bottom 50 percent of taxpayers contributed a mere 4 percent of the revenue raised under the individual income tax. Indeed, the share of income taxes paid by the wealthy increased during the period from 1983 to 1999, most dramatically after 1993. On the other hand, there is no need to feel sorry for the rich, as their share of household income, total net worth, and financial wealth (net wealth excluding houses and autos) is also greatly disproportionate to their numbers.9 While the rich certainly pay their fair share of taxes, they also own more than their fair share of the national wealth. Furthermore, the already unequal distribution of wealth in this country became even more concentrated during the period of economic boom experienced in the 1990s.10 So while the share of income taxes paid by the wealthy increased in the 1990s, their net after-tax position was considerably better off in 1997 than it was in 1983. In other words, it was good to be rich in the United States in the 1990s! This may explain why the wealthy seem so much less adamant these days (at least in public) in their opposition to government and taxes than the average Republican congressman representing Middle America. Those who are counted among the nation’s wealthiest individuals generally have the good sense and grace to keep mum; they know a good deal when they see one.

7

Introduction Because a tax cut benefits only those who pay taxes, and because it is the wealthiest taxpayers who bear most of the burden of the income tax, the rich inevitably will enjoy most of the benefits of a major reduction in taxes. The quintessential problem for antitax Republicans is that while their tax-cut proposals appeal to the wealthiest voters (although certainly not all those who benefit most from tax cuts favor them over alternative policies—witness the February 2001 campaign led by billionaires Bill Gates Sr. and George Soros to retain the federal estate tax11), there are just not enough wealthy voters to sweep Republican candidates into office strictly on a platform of tax cuts. In other words, playing to a small number of wealthy voters creates an initial problem for Republicans trying to win electoral contests. Taking a position contrary to the economic interests of a majority of American voters (who most definitely are not wealthy) is a risky strategy, although certainly there are times when politicians take positions contrary to public opinion without suffering adverse effects.12 Still, absent some manifestation of “false consciousness” afflicting the lower and middle classes (the equivalent of what used to be called “working-class toryism” in postwar England) or incredibly clever marketing by the political operatives (for example, selling the so-called flat tax, which disproportionately benefits the wealthy under the guise of tax “reform” and “simplicity”), running on a platform of tax cuts for the rich should be insufficient to carry Republican candidates to victory. Fortunately for the Republican party (and everyone else), voters do not always vote based on a pure rational calculation of economic self-interest. Occasionally, voters are even swayed by arguments and reasoning. Of course, sometimes they do suffer from false consciousness and succumb to clever marketing. At any rate, a platform of tax cuts is obviously not a fatally flawed or impossible strategy for the Republican party—as witnessed by the numerous successes of antitax GOP candidates over the decades. It worked for conservative Republicans in the 1920s, the late 1940s, throughout the 1980s, and then again in 1994. It appears to have contributed to the success of George W. Bush in the 2000 presidential election, although there is no firm evidence that his platform of tax cuts helped give him the slight edge in the electoral college that ultimately landed him in the White House. Despite this, some Republican pollsters profess that running on a platform of tax cuts is the only campaign strategy that works for Republicans. That is debatable. However, so long as liberal Democrats cooperate by constantly raising taxes to finance the ever-expanding array of social welfare programs administered by the post–New Deal state, Republicans will have a ready-made issue at hand justifying a new round of proposed tax cuts. Of course, even when a platform of tax cuts works as a successful campaign theme, actually reducing taxes in office is something else. The income tax (individual and corporate) is the source of over 60 percent of the revenue of the federal government, and a program of tax cuts is neither an easy nor rational strategy for a politician actually occupying a seat in government. Because the enormous 8

Introduction revenue raised by the Social Security payroll tax is dedicated to that retirement/ income support program, it is the income tax that supports virtually all the discretionary spending that politicians use to bestow government programs and benefits upon their constituents. Politicians typically distribute these benefits to constituents in an effort to cultivate their support and votes in an effort to get reelected—or at least, that is one major theme in the political science literature.13 So it would be perfectly logical even for those candidates who ran on a platform of tax cuts to downplay or outright ignore the whole question once in office. In other words, while tax cuts may make for a compelling campaign theme, it should not be surprising to see elected politicians (even antitax Republicans) feel the pressure of other incentives and accordingly, pursue other interests once in office. There is a distinct disjuncture between antitax campaign rhetoric and the political reality of an elected official trying to keep his job.14 However, this disjuncture most definitely can be overcome. The most prominent Republican politician who ran a successful antitax electoral campaign and managed to implement a program of tax cuts once in office was the former movie star turned politician, Ronald Reagan. The contemporary Republican antitax campaign owes its greatest debt to Reagan. As President in the 1980s, Reagan laid the foundation for the antitax politics of the 1990s. As will be described in greater detail in the chapters that follow, Reagan’s preoccupation with cutting taxes was nothing new in the Republican party—his was just a more successful campaign. Reagan ran on antitax themes and came to the presidency ready and willing to cut taxes. Once in office, Reagan wasted no time presenting his tax reduction plan to Congress. Even with Democrats retaining a majority in the House, Reagan was able to steer his proposal through Congress. This turned out to be the greatest tax cut in the history of the federal income tax. After eight years in office, tax policy ended up the centerpiece of the Reagan administration’s domestic policy. To be sure, when Reagan moved into the White House, there were other important political issues on the new President’s agenda besides tax cuts. There was much talk of getting government “off the backs” of American citizens, eliminating whole cabinet offices, and generally cutting back Big Government in Washington as it had evolved since the New Deal of the 1930s. However, it turned out that these bold objectives were not so easy to achieve. Entrenched economic interests and organized political interest groups (many associated with the Republican party itself ) resisted the efforts of the Reagan administration to cut back the federal bureaucracy. Only minimal cuts were made to domestic spending, and these were more than outweighed by significant growth in other government departments—most notably, increased spending on the U.S. military. Cutting programs proved difficult, if not impossible, but cutting taxes was politically feasible. As a consequence, overall government spending increased, while tax revenues were substantially reduced during Reagan’s two terms. In the end, the great domestic policy success and legacy of Ronald Reagan (surely, the 9

Introduction most successful Republican president since Theodore Roosevelt) was reducing taxes for American taxpayers, while leaving the federal government buried under the weight of mounting budget deficits. After Reagan’s departure from office, his successor was forced to deal with economic reality. Therein lies the irony of Reagan’s success. Tax cuts may provide a winning campaign agenda for a Republican candidate running for office, and with the right mix of political skill and good luck may even be implemented once in office. However, the economic consequences of major tax cuts take years to be felt, and they generally come after the antitax candidate has retired from office. For better or worse, Ronald Reagan never had to face the consequences of his antitax policies. Unfortunately for George H. W. Bush, he did. As soon as he took office, Bush confronted mounting deficits and worsening economic conditions. Soon thereafter, he was drawn into an ill-fated compromise with the Democratic congressional leadership that produced an agreement for significant tax increases—this notwithstanding the President’s infamous “no-new-taxes” pledge at the 1988 Republican nominating convention in Houston. The 1990 tax increase badly tainted Bush in his 1992 presidential campaign. In particular, his credibility was undermined and his support diminished among conservatives—especially with the antitax wing of his own party. On top of that, Bush’s campaigning proved uninspired in his bid for reelection in 1992. The result was a victory for the young Democratic candidate, former Arkansas governor Bill Clinton. When Clinton defeated Bush, antitax Republicans were dealt a devastating setback. After all, Clinton had expressly campaigned in 1992 on a platform calling for a tax increase for the wealthy (a “millionaire’s surtax”) to reverse the tax reduction enacted during the Reagan years. It was not long before the Democrats in Congress followed through on the President’s campaign pledge. In 1993, Democrats pushed through legislation that raised taxes for the wealthiest Americans taxpayers by 20 percent. Would the Republican tax cuts of the 1980s be reversed in only the first year of Democratic rule? It surely looked that way. The antitax wing of the GOP was out of power and repudiated by the American electorate, which apparently preferred a Democrat running on a platform of tax increases over the incumbent “no-new-taxes” Republican president. This was a new low point in the history of the antitax wing of the GOP. At the time, it appeared to signal the demise of what was left of the so-called Reagan Revolution. Democrats in the White House and Congress controlled the decisionmaking for tax policy, and the Republican party was in disarray. Would Republicans suffer the same political fate that they endured during the 1960s and 1970s? Things could not have looked bleaker for the antitax cause. Then unexpectedly, the Right Wing of the Republican party made one of the most remarkable comebacks in the history of American politics. All across the country, Republicans running on their “Contract with America” platform swept Democratic candidates in the November 1994 congressional elections. As a 10

Introduction result, the Republican party found itself with a majority in both houses of Congress for the first time in forty years. Most important, the Right Wing of the GOP regained control of the party, and its antitax message found new life. If the antitax sentiment of the Republican party in the mid-1990s was not exactly new, it certainly was more extreme in its expression. In the 1980s, Ronald Reagan had succeeded in transforming “tax reform” (qua tax reduction) into a viable, winning political issue for the GOP. But while Reagan and his supply-side cohorts stressed reducing income tax rates, they never questioned the legitimacy of the federal income tax. That is where the Republican party of the 1990s departed from tradition, for the new party leadership not only called for reducing taxes, but openly questioned the role of federal taxation in a free society— even repeatedly proposing repeal of the Sixteenth Amendment to the U.S. Constitution, which provides Congress with clear and plenary power to impose an income tax.15 On this account, the heated rhetoric of the antitax wing of the GOP must be distinguished even from Reagan’s conservative philosophy of limited government and tax reduction. To be sure, Reagan had proposed tax cuts. But what the new conservative Republicans now proposed was more in the order of a would-be fiscal revolution. They envisioned a complete refinancing of the American state. Most important, that refinancing would leave the wealthy with a significantly greater share of their money and the government in Washington with significantly less revenue—at the same time, permanently restricting the scope and activities of the national government. The federal income tax would be replaced with some less intrusive form of taxation (e.g., a “flat tax,” VAT, or national sales tax), the gift and estate tax would be scrapped, other minor nuisance taxes (e.g., a 3 percent federal excise tax on telephone calls that has been around for over one hundred years) would be eliminated, and the government in Washington would be limited by its own inability to finance the kind of social welfare programs that most have assumed to be legitimate functions of the national government since the New Deal. A new proposed constitutional amendment would mandate a balanced budget and require a special 60 percent majority for any future tax increases.16 What Republicans came to refer to in the 1990s as “fundamental tax reform” would be the death knell of the modern social welfare state in America. They never quite came out and said this was their goal, but by so significantly cutting back the sources of revenue of the federal government, this surely would be the result. The battle to dismantle the post–New Deal state was not yet over—or at least, the new generation of conservative Republicans was not yet willing to concede. As soon as the GOP took control of Congress in January 1995, the campaign against the federal income tax commenced. During the next six years, Republicans in Congress battled the Democratic Clinton administration and squabbled among themselves over how to cut taxes. The Republican congressional leadership proposed massive income tax cuts. They also proposed the 11

Introduction elimination of other taxes entirely, such as the gift and estate tax—this without regard to particular economic circumstances or budgetary constraints. At the beginning of the decade, with the economy in recession and the Congressional Budget Office (CBO) projecting decades of massive deficits, Republicans prescribed the orthodox Keynesian formula to stimulate the economy: cut taxes. By the end of the decade, in the wake of an amazing eight-year run of a booming economy that led CBO to issue new projections of trillions of dollars in surpluses, the GOP still unwaveringly advanced its agenda for tax cuts. For fiscal year 2000, the government enjoyed a record surplus of $237 billion as the economy continued to boom. Tax cuts were needed to give back to the taxpayers “their” money. Then when the economy slowed, Republicans again proposed tax cuts as the remedy, this time to stimulate the economy. According to this argument, a forthcoming recession dictates massive tax cuts, just as eight years of boom did. To antitax Republicans, tax reduction is always the appropriate economic policy. Much the same can be said for Republican presidential candidates. In 1996, Bob Dole ran on an economic program that included a broad-based 30 percent tax cut. In the 2000 presidential campaign, GOP candidate George W. Bush pushed for a ten-year tax cut of some $1.6 trillion—surpassing what even the most ardent antitax Republicans in the House were then proposing. After moving into the White House following one of the closest elections in history, Bush persisted with his plan for a large-scale tax cut. In the end, it makes no difference to Republicans whether the economy is booming or in recession, whether government is suffering sustained budget deficits or enjoying trillion-dollar surpluses. Republican tax policy demands tax cuts—period! In the 1990s, the GOP antitax campaign took direct aim at the federal agency charged with administering the tax laws: the Internal Revenue Service. Hearings into alleged IRS abuses were conducted. The IRS was ridiculed, reprimanded, and reorganized. Republican members of Congress took to referring to the tax laws as the “IRS Code”—conveniently ignoring that it is Congress, not the IRS, that writes the Internal Revenue Code. They even cast suspicious eyes on the Social Security program, the nation’s most successful and costly domestic program. In the new political climate, Republicans proposed radical changes to Social Security: new methods of financing Social Security, and even “privatizing” the retirement program. In the end, a Democratic president in the White House, along with a relatively small number of liberal Democrats in Congress, blocked virtually all of these proposals. But if congressional Republicans lost most of these political battles in the 1990s, they continued to wage the war. Tax cuts, the IRS, and Social Security were continually in the news, on the bargaining table, and subject to public debate and scrutiny. When their campaign for an $792 billion tax cut fizzled in 1999, congressional Republicans advanced a new list of discreet, “targeted” tax cuts for married couples, small businesses, farmers, and the parents of college students. Just about everyone would get some tax benefit—just not all at once. 12

Introduction Ironically, the future of the antitax wing of the Republican party became considerably more uncertain following the November 2000 elections. Even with George W. Bush eventually eking out a victory in the electoral college and securing a place for himself in the White House for four years, the electoral outcome could hardly be interpreted as a victory for Republicans or the antitax movement—or even for Bush himself (who lost the national popular vote, for what that is worth). After the election, the GOP retained a slim majority in the House of Representatives, thereby assuring that leadership positions and committee chairs would remain in Republican hands for at least two more years. However, the Senate ended up deadlocked with 50 Republicans and 50 Democrats. Only the potential vote of Vice President Dick Cheney gave the GOP control over the leadership positions in the Senate. Republicans retained a very tenuous hold on the 107th Congress during the first five months of the opening session. However, they certainly made the most of it, passing a $1.35 trillion tax cut pursuant to the Economic Growth and Tax Relief Reconciliation Act of 2001. Then the defection of a single Republican Senator (Jim Jeffords of Vermont) cost the GOP its majority in the Senate, and with that, control of the tax policy agenda. How these events in Washington will affect Republican strategy in the coming years is uncertain. Most ominous for the GOP is the closely divided partisan composition of Congress. Given the renewed vitality of the Democrats, it will be difficult for the antitax Right Wing of the Republican party to achieve more of its objectives during the 107th Congress. Before reclaiming control of the Senate in June 2001, Democrats seemed to accept the inevitable—some form of a Republican tax cut would be enacted. And so it was. But soon enough, Democrats realized that they still had the capacity to influence any Republican initiative and put their own mark on any tax legislation that would be enacted. That was achieved in the negotiations leading up to enactment of the 2001 tax act. President Bush’s plan for a $1.6 trillion tax cut over ten years was reduced to a $1.35 trillion tax cut over eleven years. A number of Democratic tax proposals providing aid to education were included in the final bill. Then, after gaining control of the Senate, Democrats found themselves with leverage to stall, and even block Republican tax initiatives. If that negative power is exercised during the rest of the Bush presidency, partisan deadlock will again dominate the tax legislative process. Certainly, the momentum of the Republican antitax movement has already stalled. Still, Senate Democrats on their own cannot repeal the 2001 tax cut. The Republican opposition to any such attempt would be too strong. With Republicans remaining in control of the House and presidency, such an effort would not likely succeed. Of course, things can change. If Democrats hold the Senate and recapture the House in the 2002 midterm elections, there will be strong pressure to return to the traditional Democratic fiscal policies, characterized by high marginal tax rates and increased spending. However, Democrats would also need to capture the White House in 13

Introduction 2004 to regain full control of the tax legislative process. More likely is that “mixed” government will continue. If so, several scenarios are possible. One is that Republicans and Democrats could cooperate by enacting matching tax provisions for the benefit of the respective parties. This spirit of bipartisanism was expressed by Vice President Dick Cheney when he suggested pairing a Republican proposal to reduce taxes on capital gains with a Democratic measure to increase the minimum wage. However, the result of such bipartisan logrolling is usually tax legislation that neither party really wants. The rest of us should take a hint from that. The most likely scenario is that partisan deadlock will take hold of the tax legislative process for the rest of the Bush years. Of course, sometimes deadlock is the best possible outcome for the nation as a whole. At least things do not get worse when there is a stalemate. On the other hand, the prospects for a new and improved federal tax policy do not look very promising either.

This book is a study of the antitax policy of the Republican party that has dominated our national politics in recent decades. By the force of their convictions, the leaders of the antitax wing of the Republican party set the policy agenda in the 1990s and eventually passed a major tax cut in 2001. For that reason alone, their ideas merit our attention. In the chapters that follow, I trace the origins and history of the ideas of the antitax wing. I explain how antitax conservatives took control of the Republican party in the 1980s and Congress in the 1990s, and to what effect. The possibility that conservative Republicans lost control of the tax policy agenda in 2001 is also considered. The scheme of the book is as follows. Chapter 1 provides a brief history of the birth of the Republican party in 1854 and the adoption of the first federal income tax during the Civil War. The early origins of antitax sentiments in the GOP during this period are explored. By the turn of the century, conservatives dominated the Republican party and the GOP governed the nation. Their conservative tax and fiscal policy prevailed during the 1920s. This changed dramatically with Franklin Roosevelt’s election in 1932. The precarious position of the GOP as a minority party during the New Deal is discussed in chapter 2. Likewise, the content of New Deal tax policy is examined. After Roosevelt’s death and the end of World War II, the Right Wing of the Republican party reemerged as the dominant faction in the party. The rhetoric and ideology of contemporary antitax Republicans can be traced to this period in the history of the party. The Right Wing of the GOP went into decline after 1954, and then, after rearing its head again in 1964 with the nomination Barry Goldwater, was crushed by Lyndon Johnson and the liberal onslaught of 1964. The Right Wing made a recovery in 1980 with the election of Ronald Reagan. During the Reagan years, major tax reduction legislation was enacted in 14

Introduction 1981 and 1986. The Reagan tax cuts are discussed in chapter 3. Likewise, the largely unsuccessful tax policy of the administration of George H. W. Bush is recalled. In November 1994, the Right Wing of the GOP made a spectacular comeback. With the return of the Right Wing came the resurrection of conservative antitax policies. The tax legislation proposed and actually enacted during the 1990s is described in chapter 4. Special attention is devoted to the “new” conservative Republicans who came to Washington as part of the freshman class of the 104th Congress. While a Democrat occupied the presidency for most of the decade, Republicans controlled both houses of Congress after January 1995. Thereafter, intense political battles over tax policy raged between congressional Republicans and the Clinton administration. Despite the conflict, substantial tax legislation was enacted throughout the decade. Some of it was tax law initiated by Democrats, some by Republicans. Most of it rendered the tax code even more complicated and incoherent. Tax policy in the twenty-first century is the topic of chapter 5. The recent policies of congressional Republicans, as well as those of the conservative administration of George W. Bush are discussed. The prospects and possibilities of federal tax policy during the Bush administration are considered. In particular, the successful campaign for tax reduction that culminated in the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 is recounted. The GOP campaign against the federal estate and gift tax (or “death tax,” as Republicans like to call it), which culminated in Congress voting for repeal pursuant to the 2001 tax act, is recounted in chapter 6. In the 1990s, President Clinton’s veto repeatedly blocked Republican efforts to repeal the tax. The basic principles of the estate and gift tax are described in this chapter, as are the various arguments advanced in favor of retaining and repealing it. Given the outcome of the November 2000 presidential election, it was inevitable that Republican efforts to repeal the estate and gift tax would persist. With the enactment of major tax legislation in May 2001, the Republican effort finally succeeded. Or did it? After a 10-year phase-out, the estate tax rises from the ashes in 2011 unless Congress kills it for good before that date. Inevitably, the entire political issue must be revisited by Congress in the years to come. Supposedly shut down by the Tax Reform Act of 1986, tax shelters made a big comeback in the 1990s. Only this time, there was a new form of tax shelter. Large corporate taxpayers “invest” in multimillion-dollar deals concocted by a new breed of tax promoters led by the “Big Five” accounting firms and Wall Street investment bankers. Significant tax losses are generated, which reduce the corporation’s tax liability—this at the expense of the U.S. Treasury. Efforts by the White House and Treasury Department to clamp down on the new corporate tax shelters met with indifference from the Republican leadership of Congress. This should be no surprise as corporate America contributes a good deal of money to the electoral campaigns of Republican candidates across the nation. The corpo15

Introduction rate tax shelters cost the U.S. Treasury billions of lost tax revenue during the 1990s—no one knows exactly how much! The story behind these corporate tax shelters, as well as Republican apathy toward government efforts to shut them down, is the subject of chapter 7. Beginning in late 1996 and early 1997, the Congressional Budget Office began to predict that years of budget deficits would turn around. Soon after, CBO estimated that the federal government would run huge budget surpluses over the coming decade—some $3 trillion in surplus over ten years. Later, the estimate swelled to $5.6 trillion. None of this surplus was actually in the federal treasury, but politicians immediately recognized the potential benefits of even these projections of surplus funds. Democrats proposed increased spending on social welfare programs (expanded Medicare coverage for prescription drugs, new tax credits for education expenses, etc.), while Republicans once again proposed massive tax cuts. Tax policy in the Age of Surplus is the subject of chapter 8. In the 1990s, the Republican leadership of Congress also dared to breach a previously forbidden subject: privatizing the U.S. Social Security program. Generally considered the “Third Rail” in American politics, even conservative Republicans traditionally refrained from questioning this major social welfare program. GOP presidential candidate Barry Goldwater tried to voice a challenge in 1964, but was pilloried by the electorate. Yet, in the 1990s, Republicans dared to touch the Third Rail and lived to tell about it. What changed in American politics over the past three decades to account for this? Republican plans to reorganize the Social Security program also are assessed in chapter 8. Finally, in the book’s conclusion, I assess the overall impact of the antitax wing of the Republican party on contemporary tax policy. There I also consider whether the antitax agenda has worked for the GOP as a campaign strategy. Furthermore, the prospects of conservative Republicans implementing their fiscal revolution are weighed. The conclusion is that despite their recent legislative success in reducing taxes, they have enacted remarkably little of their agenda, especially given that the economic and political climate was most conducive to their plan to restructure the finances of the nation. After losing control of the Senate to the Democrats in June 2001, antitax Republicans will likely meet with even less success in the years to come. In any event, it is not so easy to refinance America. Despite some strong and pointed criticism, the overall goal in this book is not to bash Republican tax policies, but rather explain them. Many of the tax proposals advanced by congressional Republicans are quite sensible; others are little more than instrumental manipulation of the tax code to appease powerful interests in the party coalition and gain voter support. Some Republican proposals might very well improve the U.S. tax system and perhaps even strengthen the economy; others are poorly thought out and would likely be destructive of the fiscal solvency of the federal government. In the latter category are policies that 16

Introduction reflect antitax ideology more than common sense or the dictates of sound tax policy. Separating the wheat from the chaff is never easy, but that is the goal here. In recent years, there certainly has been no shortage of chaff proposed. Unfortunately, a good deal of it has actually found its way into the tax code. Republicans and Democrats alike share the blame for that!

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The Origins of Republican Tax Policy [S]ocialism, communism, [and] devilism. —Senator John Sherman of Ohio (1894), denouncing the new federal income tax of 1894 It will be an evil day for us when we enter on confiscation of property under the guise of taxation. . . . [T]o have the Government undertake, for vindictive reasons, to punish a man simply because he has succeeded and has accumulated property by thrift and intelligence and character, or has inherited it honestly under the law, is entering upon a dangerous path. It would convert this tax from the imposition of a tax to a pillage of a class. —Senator Henry Cabot Lodge of Massachusetts (1913)

The Republican party has enjoyed a long history and mixed fortune in American politics. The dominant political organization in the United States during the Civil War, and then again in the late nineteenth and early twentieth centuries, the GOP was reduced to a distinctly secondary role in the new national party system that emerged during the 1930s. Virtually without a presence in the solidly Democratic South, and elsewhere overwhelmed by the New Deal coalition of organized labor, immigrants, and racial minorities, the Republican party endured for decades following the New Deal by holding on in its enclaves in the Midwest and Northeast. Even after making significant inroads in the South and West in the 1960s and 1970s, as well as winning the White House in a majority of postwar presidential elections, the post–New Deal Republican party remained the perennial minority party in Congress. That would change dramatically in 1994. Within the Republican party itself, the conservative Right Wing (what used to be referred to as the “Old Guard”1) has generally been a minority faction dominated by a moderate center and checked by the liberal wing of the party. However, periodically the conservative Right Wing has held the reins of the party, and at times set the legislative agenda in Congress. That was the case in the 1920s, from 1946 to 1954, and then again following the 1980 Reagan electoral 19

The Origins of Republican Tax Policy landslide. It happened again in 1994 when the Republican party took control of both houses of Congress for the first time in forty years. It is from within this conservative faction of the GOP that the most vocal and committed antitax rhetoric has emanated. In prior decades, the Right Wing also obsessed over the Soviet Union and the spread of communism. Indeed, anticommunism was the dominant concern, as well as the bread-and-butter political issue for the Right Wing in the immediate postwar era. With the demise of East European Communism beginning in 1989 and the subsequent collapse of the Soviet Union and its military threat, the Right Wing turned inward, focusing on domestic policy issues. By the 1990s, hostility to federal taxes emerged as the driving force of contemporary conservative ideology, which came to direct the thinking of the Republican party itself. Antitax sentiment in the GOP dates back to the Civil War, when Republicans from New England opposed a federal income tax, even while the majority of the party was willing to accept the impost as a necessary means of financing the Northern war effort. Likewise, in 1894 and 1913, Progressives and moderate “centrists” within the GOP supported, or at least acquiesced, in a relatively minor assessment on personal income. On the other hand, Old Guard conservatives remained firm in their opposition to any federal income tax or inheritance tax. For the next eighty years, conservatives in the GOP remained consistently opposed to federal income taxation. For much of that time, antitax conservatives were kept in check within their own party by the moderate center. However, that changed dramatically with the decisive election of Ronald Reagan to the presidency and then the unexpected and dramatic victory of conservative Republicans in the 1994 elections. With that victory, the conservative antitax faction came to the forefront of the party. By then, the liberal wing of the GOP was virtually extinct and moderates were reduced to a minority faction. The antitax campaign of conservatives got an additional boost when George W. Bush won the November 2000 presidential election. A major tax cut followed less than five months later. The current Republican antitax campaign has its origins and antecedents in the long and complicated history of the Republican party as it evolved after the Civil War. The party itself changed dramatically in the 1890s when it achieved preeminence in the political system, and then again when it was reduced to minority status with the rise of an overwhelming Democratic majority in the 1930s. Notwithstanding these significant changes in the party system, there remained a remarkable consistency and depth to antitax principles within the Republican party. Republicans and the Civil War Income Tax With the election of Abraham Lincoln in 1860, the Republican party won the White House in only its second national presidential campaign, just six years 20

The Origins of Republican Tax Policy after the founding of the party. Lincoln’s election also provoked the boldest proponents of secession in South Carolina, who knew exactly where the new President stood based on the widespread publicity given his speeches from the Lincoln-Douglas debates. When Southern Democrats departed the Congress and seven Southern states (soon joined by four more) asserted their right to secede from the Union, Lincoln formed his government and the Republican party effectively took control of the entire government in Washington. The party of opposition (a ragtag coalition of former Whigs, anti-Nebraska Democrats, and “Free-Soilers” in the North) became the governing party.2 Ultimately, the great national dispute over slavery and states’ rights was settled on the battlefields of the Civil War. There the Union ultimately prevailed, and the Republican party emerged as the dominant political organization in the United States. But that was years later. During the first year of the Civil War, the new Republican administration faced a grave crisis of public finance—funding the war effort. Traditional nineteenth-century sources of revenue for the national government proved inadequate, and a new income tax was proposed by moderates within the Republican party. Therein began the long and stormy relationship between the Republican party and the federal income tax. During the first year of the Civil War, Lincoln and his secretary of treasury, Salmon P. Chase, faced a mounting revenue crisis as the government geared up for the war effort. To make matters worse, the federal government had already run three successive deficits following the Panic of 1857, mounting a deficit of $50 million by the end of fiscal year 1860. Thus, the financial resources of the Republic were already severely strained by the time hostilities broke out. Ultimately, the war effort drove up annual government spending from less than 2 percent of gross national product to an average of 15 percent. The administration initially believed that the war could be funded through a combination of public borrowing and regressive consumption taxes—namely, the tariff and a handful of other federal excise taxes imposed on consumer goods. In July 1861, Treasury Secretary Chase issued a report calling for $20 million more to be raised by direct taxes, internal duties, and excise taxes. Confronting unprecedented spending for the military campaign and a resulting budget deficit, congressional Republicans approved legislation to raise the tariff. In fact, tariff rates were increased every year throughout the war. Still the deficit mounted as revenue continued to lag behind war expenditures. Republican congressional leaders worried that excessive reliance on the tariff would turn Western and border states against them. There also was some sentiment for a national property tax—at the time, the main source of local government revenue. Thaddeus Stevens of Pennsylvania, powerful Republican chairman of the House Ways and Means Committee, proposed a direct land tax to be allocated to each state in proportion to its population —the latter, a constitutional requirement.3 Treasury Secretary Chase supported Stevens’s proposal for a national property tax. On the other hand, Stevens’s proposal for a direct tax on land provoked intense opposi21

The Origins of Republican Tax Policy tion among representatives from the South and West, where agricultural interests with much to lose were predominant. In response to calls for tariff increases or a national property tax, Justin Morrill, an abolitionist, co-founder of the Republican party in Vermont, and important member of the House Ways and Means Committee, offered a compromise proposal in July 1861 that included a minor federal income tax to supplement the tariff. Most Republicans in Congress preferred Morrill’s compromise proposal for an income tax over a national property tax or further tariff increases. Republicans from the Northeast remained strongest in their opposition to the income tax proposal; however, they too finally acquiesced. By a vote of seventy-seven to sixty, the bill passed the House. Thereafter, the bill passed the Senate, and Lincoln signed it into law on August 5, 1861. The new income tax imposed a 3 percent tax on all income above a $800 personal exemption. The income tax on U.S. citizens residing abroad was 5 percent, and the tax on interest income from securities was reduced to 1.5 percent. Because of the generous exemption, only the wealthiest citizens were initially subject to the impost. The editors of the New York Times subsequently praised this new tax, “levied upon a person’s purse,” as “probably one of the most equitable and bearable taxes that can be imposed.”4 Of course, newspaper men are not among the most generously paid or wealthiest citizens, and their own salaries were not likely to exceed $800 a year, and hence were beyond the reach of the tax. Owing to difficulties implementing the statute, the income tax of 1861 was never actually put into effect by the Treasury Department and never raised a single dollar of revenue. Subsequently, a new income tax was passed by the Republican Congress and signed into law by Lincoln on July 1, 1862,5 as part of a wide-ranging revenue act that also imposed a tax on the gross receipts of railroads, banks, trust companies, and insurance companies. As part of the same revenue package, the Republican Congress enacted a national gift tax and a 5 percent inheritance tax on the receipt of property in the form of “legacies.” The income tax of 1862 called for a 3 percent tax on the “annual gains, profits or incomes” above $600 of anyone residing in the United States, “whether derived from any kinds of property, rents, interest, dividends, salaries or from any profession, trade, employment or vocation carried on in the United States or elsewhere, or from any source whatever.” The tax rate increased to 5 percent on income in excess of $10,000 and on all income earned by citizens residing abroad. The provision provided for withholding on the salaries of government employees and also expressly allowed limited business deductions. Justin Morrill defended the new Republican income tax as the “fairest” means for raising revenue for the war effort: “The income tax is an inquisitorial one at best; but upon looking into the considerable class of state officers, and the many thousands who are employed on a fixed salary, most of whom would not contribute a penny unless called upon through this tax, it has been thought best not to wholly abandon it. Ought not men, too, with large incomes, to pay more in 22

The Origins of Republican Tax Policy proportion to what they have than those with limited means, who live by the work of their own hands, or that of their families?”6 Morrill, a key Republican with considerable experience in public finance, had no qualms about adopting an income tax per se. However, he objected to a progressive rate structure that imposed a disproportionately high burden of the income tax on the wealthy. As always, “fairness” is in the eye of the beholder, and most conservative Republicans from the Northeast viewed a graduated income tax with considerable suspicion, if not outright disdain. As the war progressed, tax rates were repeatedly raised and the tax base further expanded. Republicans were successful in enacting such taxes because the wartime crisis gave the government considerable leeway in steering national economic policy. Taxes that were highly unpopular in prior decades (in particular, the tariff ) or opposed by powerful economic interests (i.e., the income tax) were accepted by all sides during the wartime crisis without provoking great opposition or popular resistance. During the Civil War, the Republican party (which totally dominated national politics on account of the withdrawal of Southern Democrats from the government) successfully integrated its own partisan organization and interests with those of civil society and the emerging national state.7 In this way, the party served an important integrative function during a crucial period of state-building in America. During the period of wartime fiscal crisis, the party itself was also unified. For example, Republicans who otherwise would have opposed the income tax begrudgingly accepted the impost—at least, for the duration of the war. A far more comprehensive income tax was proposed in the spring of 1864. The Ways and Means Committee reported a bill for a flat income tax of 5 percent. However, the House followed the recommendations of the commissioner of Internal Revenue in favor of a progressive rate structure.8 This provoked intense objections among a number of Republicans on the grounds of the injustice the graduated tax would inflict upon the wealthy. Representatives Stevens and Morrill led the opposition to the graduated rate structure. Stevens denounced the graduated tax as a “strange way to punish men because they are rich.”9 Morrill declared that progressive rates “punish men because they are rich,” and amount to nothing less than “seizing the property of men for the crime of having too much.”10 Morrill’s opposition was significant given that he was an original supporter of the income tax. It was the progressive rate structure with which he could not abide. In the end, the need for revenue was too great. A progressive tax rate with a high exemption is the only way to raise significant revenue from the wealthy without imposing an excessive tax burden on the poor and middle classes. Accordingly, Congress enacted a new income tax in 1864, imposing a tax of 5 percent on income over $600, rising to 7.5 percent on income over $5,000, and reaching 10 percent on income over $10,000. With these tax rate increases, the income tax became a major source of government revenue during the Civil War. 23

The Origins of Republican Tax Policy Revenue from the income tax increased from $2.75 million in 1863 to $20 million in 1864, $61 million in 1865, and $73.5 million in 1866.11 Historian Elliot Brownlee estimates that by the end of the war, as many as 10 percent of all Union households (perhaps as many as 15 percent in the Northeast) were paying the income tax.12 On the other hand, the inheritance tax never contributed very much. Following the war, once the government’s revenue demands eased dramatically, the much despised inheritance tax was repealed in July 1870.13 Likewise, income tax rates were reduced significantly after the war and a “sunset” expiration date of 1872 was added to the income tax statutes. During this postwar period, Senator John Sherman of Ohio, the influential Republican chairman of the Finance Committee (who subsequently authored the most important federal antitrust statute), exerted considerable effort trying to make the federal income tax permanent. Why were Republicans such as Sherman among those campaigning to keep the income tax after the wartime revenue crisis was over? After all, it is one thing to accept an income tax during years of military and revenue crisis, but it is something else to vote to retain the tax once the crisis has past. These actions of Sherman and other Republican leaders have long puzzled those attempting to portray the Republican party as a monolithic organization opposed to any form of income tax. The intriguing explanation presented by historian Robert Stanley is that such efforts were taken by “centrists” in the Republican party who were willing to accept a minor income tax (i.e., low rates and only mildly progressive) as a strategic means for deflecting rising populist agitation for more extreme measures to redistribute wealth. As Stanley puts it: “[T]he early [income] tax was designed to preserve imbalances in the structure of wealth and opportunity, rather than to ameliorate or abolish them, by strengthening the status quo against the more radical attacks on that structure by the political left and right.”14 So the centrist Republicans adopted a pro– income tax strategy purely for instrumental purposes, willing to accept the known evil rather than face that which they truly dreaded further down the line. Contrary to this strategy, determined opposition from conservative Republicans responding to wealthy constituents in the Northeast blocked all such attempts by party centrists to retain the impost, and the Civil War income tax was allowed to expire in 1872 under the previously enacted sunset provision. With the expiration of the income tax, the federal government again turned to the tariff for most of its revenue. Indeed, throughout years of peacetime during the nineteenth century, the tariff (supplemented by customs duties, excise taxes, and the sale of public land) supplied more than enough revenue to operate the federal government—admittedly, a government of limited functions. In the decades following the Civil War, the tariff by itself raised far more revenue than the government in Washington spent annually, providing the luxury of unprecedented and seemingly endless budget surpluses. A considerable portion of that surplus revenue was doled out by successive Republican Congresses in the form

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The Origins of Republican Tax Policy of military pensions for veterans of the Union army, thereby solidifying veterans as a core constituency within the GOP.15

GOP after the Civil War After the Civil War, the Republican party continued to dominate the national political arena, as well as most state governments—at least, those outside the South following Reconstruction.16 In the post–Civil War decades, Democrats would control the White House for only two terms, and this resulted more from defections in the GOP than strengths of the Democratic candidate. Democrat Grover Cleveland, former governor of New York, won the presidency in 1884 and then again in 1892.17 The Democratic party remained competitive in Congress by virtue of the party’s stranglehold on the South, where a one-party system prevailed for more than a century following the Civil War.18 Between 1874 and 1894, Democrats and Republicans alternated in control of the Congress and White House. During this so-called Gilded Age, a competitive two-party system flourished within the nation’s capitol, with each of the parties generally dominating their respective local territories. In 1893, with strong support from Populists in the South and West, Democrats took control of both houses of Congress. The next year, bowing to strong pressures from the Populists, Democrats instigated a campaign to reinstate a federal income tax—this time, with a steeply graduated rate structure. The platforms of the Greenback Party in 1877 and 1878 called for a progressive income tax, as did that of the National Greenback Party in 1880. The Greenback Labor and Anti-Monopoly Parties adopted similar proposals in 1884, and the Union Labor Party espoused the progressive income tax in 1888. Grangers, Knights of Labor, and the Farmers Alliance all demanded restoration of a progressive income tax, as did the Populist Party in each of its platforms. From 1874 to 1894, sixty-eight bills were introduced in Congress to restore an income tax of some sort. Needless to say, these were not Republican initiatives. Support for a new income tax was strongest in the South and Midwest. In 1893, the chairman of the House Ways and Means Subcommittee on Internal Revenue, Democrat Benton McMillin of Tennessee, introduced tariff legislation that also provided for a new income tax. William Jennings Bryan of Nebraska led the campaign on the floor of the House. While some Progressives in the Republican party joined in supporting the measure, most Republicans were strongly opposed. This was largely because the income tax was now presented in the context of the broader Populist attack on wealth and privilege. Most important, the newly proposed income tax had a graduated rate structure that posed a genuine threat to the existing social order—at least, in the minds of those who possessed a sizable share of the nation’s wealth. Among those Republicans who

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The Origins of Republican Tax Policy now actively opposed the new income tax were Justin Merrill of Vermont, who had sponsored the first Civil War income tax, and John Sherman, the prominent Republican senator from Ohio who had also supported the Civil War income tax. Sherman, one of the most important politicians of the 1870s and 1880s, and the chief architect of Republican economic policy during the period, emphatically denounced the new Populist graduated income tax as “socialism, communism, [and] devilism.”19 All Republican members of the House Ways and Means Committee voted against the tax. Notwithstanding their opposition, the campaign in Congress prevailed. A relatively minor income tax was enacted within the context of a broader compromise over tariff reduction (another important goal of farmers in the South and Midwest). Democratic President Cleveland readily signed the measure into law. The new federal income tax of 1894 imposed a flat 2 percent tax on the gains, profits, and income of individuals above the $4,000 exemption, and a comparable 2 percent tax on the “net profits” or income of all corporations, companies, and associations doing business for profit in the United States. Again, on account of the high exemption, only a small number of very wealthy individuals were subject to the tax. After all, $4,000 was a considerable sum in those days, and the vast majority of Americans (even those who were quite prosperous) were totally unaffected by the imposition of the new income tax. The tax was indeed an impost on the rich. Republican opposition to the income tax of 1894 festered even after the bill was signed into law. Soon enough, the political opposition was rendered moot as the U.S. Supreme Court heard a constitutional challenge to the new income tax in the 1895 case of Pollock v. Farmer’s Loan & Trust Co.20 Up until the 1890s, the Court had taken the position that only two taxes (capitation and real estate) were “direct” taxes subject to the apportionment requirement of the Constitution. In Pollock, this settled view was abandoned, and the Court held the new income tax unconstitutional as an unapportioned “direct” tax.21 The year after the Court’s ruling in Pollock, the Republican party regained control of the White House with the election of William McKinley. Indeed, Republicans not only took back the presidency in 1896, but they also secured control of both houses of Congress. Their coalition of Midwestern farmers, Northern industry, urban workers, Negroes, and small businessmen formed the basis for a dominant political party. The heyday of the Republican party commenced.

Republican Hegemony McKinley and his manager Mark Hanna ran what was in many respects the first modern electoral campaign. Relying upon new methods of raising political money and a well-oiled party organization, Hanna crafted an impressive electoral machine for McKinley. The election took place in the wake of the severe depression of 26

The Origins of Republican Tax Policy 1893. Responding to Bryan’s central campaign theme (the advocacy of silver currency), McKinley moved away from his intended agenda of support for protectionism and the tariff to one based on the gold standard. Bryan’s Populism proved no more appealing to a majority of the electorate the third time around, and he and the Democrats suffered a devastating electoral defeat in 1896—the party’s worst since the Civil War. Indeed, the election signaled a major “realignment” of the post–Civil War party system. Democrats retained their monopoly in the South, but after the election Republicans held an even more solid and significant monopoly in the industrial-urban centers in the Northeast and Midwest that gave them overall dominance in the party system. In only a handful of states were the parties still truly competitive. The long decline of partisanship within the electorate, as well as that of the national party system itself, had begun. Republican hegemony established by the election of 1896 continued into the twentieth century. However, Democrats took advantage of the opportunity presented to them by former President Theodore Roosevelt, who bolted his party in 1912 and ran for President as the standard bearer of his own Bull Moose Party against the incumbent, Republican Howard Taft. The Democratic candidate, Woodrow Wilson, benefited from the split in the Republican vote and won the presidency with a historic low of 42 percent of the popular vote. With the election of Wilson (only the second Democrat to occupy the White House since the Civil War), a resurgent Democratic party claimed majorities in both houses of Congress as well. With their party’s position secure in Washington, Democrats turned their attention to a new constitutional amendment sanctioning an income tax—this necessitated by the Supreme Court’s decision in Pollock. A constitutional amendment had been ratified by Congress in 1909 by a coalition of Democrats and Progressive Republicans. Ironically, the income tax amendment was proposed by Republican Senator Nelson W. Aldrich, chairman of the Senate Finance Committee, and supported by the Republican president, William Howard Taft, with the intent of deflecting the mounting campaign for a progressive income tax. Taft was particularly sympathetic to the Supreme Court’s tenuous position, fearing any weakening of its legitimacy from lingering controversy over the unpopular Pollock decision.22 Accordingly, he supported Aldrich’s proposal for a constitutional amendment, hoping to settle the matter once and for all in favor of a federal power to tax income.23 The campaign gathered increased momentum at the state level following the Democratic electoral victory in 1912. Alabama was the first state to ratify; other states, such as Pennsylvania, never did approve the amendment. Ratification by the requisite three-fourths of the states was achieved in February 1913, and the Sixteenth Amendment, which authorizes Congress to impose a tax “on income, from whatever source derived,” became part of the U.S. Constitution.24 Following his inauguration in March, Wilson immediately proposed a reduction in tariff rates and a new federal income tax statute to be enacted under 27

The Origins of Republican Tax Policy the authority of the Sixteenth Amendment. Republicans were not uniformly hostile to the idea. After all, Taft and Progressives in the Republican party had supported both tariff reduction and an income tax during the 1908 presidential campaign—as had Roosevelt four years earlier. In 1913, “insurgent” Republican Progressives again joined congressional Democrats to support a proposal for an income tax as part of a new tariff reduction bill. These Progressives had previously supported Roosevelt’s efforts to regulate monopolies and break up the large “trusts,” as well as the creation of the first generation of independent regulatory agencies in the first decades of the twentieth century (e.g., the Food and Drug Administration in 1906 and the Federal Trade Commission in 1914, as well as the revitalization of the Interstate Commerce Commission in 1906 under the Hepburn Act).25 To be sure, Old Guard conservatives remained united in their opposition to any income tax, as well as the creation of most of the new regulatory agencies.26 However, moderates within the party were considerably more temperate in their opposition. With the ratification of the Sixteenth Amendment, some form of income tax had become a foregone conclusion. The question was, What kind of income tax would be enacted? Once again centrist Republicans viewed the income tax as a preferred alternative to more radical Populist proposals. A moderate income tax would effect only a very slight redistribution of wealth, even while deflecting radical egalitarian impulses and preserving all the basic institutions and hierarchies of the established social order. Although firmly opposed to a steeply graduated rate structure, centrist Republicans, Progressives, and conservative Southern Democrats were willing to tolerate a moderate income tax similar to what had been previously enacted in 1894. A House tariff reform bill provided the perfect vehicle for introducing an income tax to offset the revenue loss. The Senate added a slightly more progressive rate structure to the income tax included in the House tariff bill (rejecting Wisconsin Progressive Robert La Follette’s pleas for a steeply graduated tax). A graduated income tax was justified by Democrats, Populists, and Progressives as a “fairer” source of revenue than the tariff—which was generally recognized as adverse to the economic interests of the basic constituencies of these parties. All recognized that the very high personal exemption would effectively exempt all but the wealthiest citizens from income taxation. This too was defended by Democrats, Populists, and Progressives on grounds of justice and equity, which were conveniently defined in terms of imposing taxes that only reached the wealthy. In the words of Democratic representative William H. Murray of Oklahoma: “The purpose of this tax is nothing more than to levy a tribute upon that surplus wealth which requires extra expense, and in doing so, it is nothing more than meting out even-handed justice.”27 A mild version of this brand of “justice” was something that moderate Republicans could live with, but not so the Old Guard. Senator Henry Cabot Lodge of Massachusetts warned that the progressive income tax represented the “pillage of a class.”28 It was Lodge’s class 28

The Origins of Republican Tax Policy that was under direct assault from radical egalitarians, and the Senator understood it full well. Notwithstanding protests from the Old Guard, a good number of Republican members of Congress viewed the final proposal as moderate and tolerable, if not exactly desirable. With remarkably little fanfare, the Senate bill was approved on October 3, 1913, and the income tax became law pursuant to the Tariff Act of 1913. The new income tax (which has been in place ever since) began as a 1 percent tax on income exceeding a $3,000 personal exemption. The tax included a 1 percent surtax that reached 6 percent on income over $500,000—an enormous sum in those days, and even today, enough to put a taxpayer comfortably in the top 1 percent of those filing returns. At such levels, only the very wealthy were subject to the new tax, as the income of the vast majority of Americans was well below the $3,000 minimum threshold for taxation. (At the time, per capita income was roughly $333 a year.) Only some 2 percent of U.S. households paid any income tax during the first several years following its enactment.29 The enactment of the income tax in 1894 and 1913 can only be understood within the context of the broader debate over the tariff—despised by Southern and Western farmers and favored by Northern manufacturing and industrial interests. The income tax was supported by Populists and Progressives not only because it directly imposed a charge on the wealthy, but also because it represented relief from the tariff. That was always the political calculation behind revenue reform legislation in the 1890s and early 1900s: tariff relief was coupled with a mildly progressive income tax. While the more extreme proponents of income taxation definitely viewed the income tax as a means for redistributing wealth, those in Congress who actually voted for the more moderate versions of the tax were hardly wild-eyed, radical egalitarians. Instead, they saw the income tax as providing enough revenue to allow for tariff relief, while at the same time deflecting a good deal of the more extreme measures from radical quarters that they feared even more. Despite the relatively innocent origins of the income tax of 1913, significant changes were made to the rate structure of the tax beginning in 1916. Wilson and his secretary of treasury, William McAdoo, bowed to further pressures from Southern Populists (led by the powerful chairman of Ways and Means, Claude Kitchin of North Carolina) to use the income tax more vigorously as a tool to redistribute wealth. This, of course, was always how Populists and Progressives wanted to use the tax. But it was actually wartime pressure for revenue, rather than such ideology, that most dramatically changed the rate structure of the new federal income tax. Taxes on the wealthy were increased because the government needed more revenue. The Revenue Act of 1916 imposed a “normal” tax of 2 percent, with a surtax of 1 percent on income in excess of $20,000, rising to a rate of 13 percent on income in excess of $2 million. Furthermore, a highly progressive estate tax was added to the arsenal of the federal government in 1916. 29

The Origins of Republican Tax Policy Wilson won his bid for reelection in 1916, defeating the Republican candidate, New York governor Charles Evans Hughes, by 594,188 popular votes and the narrow margin of 23 electoral votes. In one respect, it did not matter who won the election. Tax rates would have increased even under a Republican administration as the nation faced an impending revenue crisis with the outbreak of war in Europe and the subsequent entry into the conflict by the United States. Soon after Wilson’s second inauguration, Congress passed the War Revenue Act of 1917, which provided for a wartime surtax that reached 50 percent on individual income in excess of $1 million, and augmented the 1916 normal 2 percent tax with an additional 2 percent on income in excess of $3,000 for single persons and $4,000 for married persons. Personal exemptions were lowered to $1,000 for single taxpayers and $2,000 for married taxpayers (down from the $3,000 and $4,000 levels set by the 1916 act).30 The normal corporate rates were raised, and the excess profits tax rates were increased as well. A wartime revenue bill was also passed in 1918. This further increased tax rates on individuals and corporations in an attempt to raise additional revenue for the war effort. Other taxpayerfriendly provisions in the original income tax law (such as an exclusion for $20,000 of dividends received by an individual) were repealed to raise revenue. Between 1913 and 1920, during the period of Democratic party rule, Congress also strengthened the Bureau of Internal Revenue (increasing personnel from 4,000 to nearly 16,000) and added a professional staff of experts in taxation, accounting, economics, and law. The result was a new tax regime that could be used at once to collect considerable revenue for the federal government and redistribute wealth among the various classes of society. For Democrats, the new tax regime created during Wilson’s second administration reflected a desire to both redistribute wealth and, at the same time, preserve the basic elements of the capitalist system that produced the wealth in the first place. Despite the dire warning of Henry Cabot Lodge, there was less interest in “pillaging” the upper classes than in taxing their wealth and using the revenue to finance a modern administrative/regulatory state. As Elliot Brownlee puts it: “Redistributional taxation . . . became a major element of the Wilson administration’s program for steering between socialism and unmediated capitalism.”31 The aim of Wilson’s “New Freedom” program was to tame capitalism for the benefit of the common man. This is precisely how liberal Democrats have viewed the income tax ever since—as a tool for effecting a mild redistribution of wealth for the benefit of the middle and lower classes, without otherwise seriously disturbing or disrupting the basic free-market economic system that produces most of the national wealth. The purpose of the income tax is to even out the economic inequality that inevitably comes with an economic system of “unmediated capitalism.” Republicans centrists were in basic agreement. In the end, the difference between Wilsonian Democrats, Progressives of all persuasions, and centrist Republicans was merely a matter of a few percentage points at the margin of the new income tax. On the other hand, the difference between the 30

The Origins of Republican Tax Policy Old Guard and Populists such as William Jennings Bryan was considerably greater—no less than a dispute over the very legitimacy of the federal tax system. In 1916, the Supreme Court addressed the specific question of the constitutionality of the graduated rate structure of the new income tax. In Brushaber v. Union Pacific Railroad Co.,32 the Supreme Court held, among other things, that the graduated rate structure did not violate the “due process” clause of the Fifth Amendment. Notwithstanding claims that persist among fringe right-wing elements to this day, the main constitutional questions regarding the income tax were settled over eighty years ago with the ratification of the Sixteenth Amendment and the blessings of the Supreme Court. After the Court’s decision in Brushaber, the Old Guard wisely gave up challenging the constitutionality of the income tax and moved the attack from the federal courts back into the political arena. There the focus became reducing tax rates, rather than repealing the tax outright. During World War I, when the income and estate tax rates skyrocketed as the government scrambled for additional revenue, even the Old Guard accepted the high rates. After the war, conservatives fought back, attempting to withdraw the wartime tax regime. However, as the income tax replaced the tariff during World War I as the principal source of revenue for the federal government, even the most conservative Republicans recognized that it was no longer feasible to repeal the tax outright. They would have to settle for tax cuts. That became one of the prime objectives of the Republican party in the twentieth century. The reign of the Democratic party from 1912 to 1920 proved to be a shortlived interruption of Republican domination of national politics. There was no long-term realignment of the electorate or reconstitution of the party system. The rift occasioned by Roosevelt’s break from the Republican party healed following World War I. In 1918, propelled by a backlash among business leaders and corporations, the GOP regained control of both houses of Congress. After Wilson’s two terms as president (during the last two years of which Wilson was seriously incapacitated), the Republican candidate, Warren G. Harding of Ohio, easily won the White House in 1920. The margin of victory was decisive, with Harding capturing over 60 percent of the vote over the Democratic candidate, James Cox. Republicans held an astounding 303 to 131 majority in the House and a 24-seat margin in the Senate. Congress and the White House were again in Republican hands, the Progressive movement had spent its course, and conservatives dominated the GOP. The 1920s belonged to the Old Guard.

Return to Republican “Normalcy” At its birth, the Republican party was a political organization comprised of a wide spectrum of social, economic, and regional interests. While the party’s greatest strength was in the Northeast and Midwest, nevertheless, it was a broad31

The Origins of Republican Tax Policy based political coalition that ran on a national party platform. After all, the Republican party was created at its inception as a “fusion” party of varied interests united in their opposition to the extension of slavery into free territories and the preservation of the Union. However, in the decades following the Civil War, the GOP became more closely associated with sectional interests and the old established order of wealth, business, and industry. During the 1870s and 1880s, new manufacturing and industrial interests in the Northeast and Midwest gravitated toward the party. In the election of 1888, the Republican party instituted a new system of party finance. Deprived of the benefits of the patronage system by the Democratic Cleveland administration, the out-of-office Republicans turned to big business and industry to finance its electoral campaign. The Republican National Committee worked with newly created businessmen’s “advisory committees” to aid in raising funds for the party. Among the most successful of these was Philadelphia department store merchant John Wanamaker, who worked closely with the Manufacturers’ Club of Philadelphia to raise substantial sums for the Republican party.33 By the turn of the twentieth century, the post-McKinley Republican party was very much the party of wealth, order, and privilege. Even still, the Republican coalition also included Midwestern farmers, urban workmen, Negroes who voted in the North, and small businessmen all across the country. The wealthy Northern patricians and industrialists were generally represented in the GOP by the conservative Old Guard faction. New England was the bastion of the Old Guard, with strongholds in Maine, Massachusetts, Connecticut, New York, New Jersey, Pennsylvania, and Delaware. In general, the party leadership also reflected the Old Guard conservative ideology. The party had its moderate center, as well the remnants of the Progressive Roosevelt wing. But with the close of Wilson’s second term in 1920, the GOP was returned to power in a landslide victory, and the conservative faction controlled the party. Harding and his secretary of treasury, Andrew Mellon, pursued a conservative fiscal and tax policy designed to bring a “return to normalcy.” In the domain of public finance, this meant reducing income tax rates to prewar levels. Except among a small minority faction, there was no sentiment within the GOP for repealing the income tax outright. The goal was to strip it down to a form and structure closer to what centrist Republicans had accepted in 1894 and 1913. The 6 percent surtax imposed under the original 1913 income tax had only slightly increased in the initial years prior to the outbreak of war in Europe. However, as soon as the United States entered the fray, income tax rates skyrocketed. The surtax on higher income levels was repeatedly raised throughout the war years. By 1918, the top marginal rate (including the surtax) reached a staggering 77 percent on personal income over $1 million. So the return to normalcy translated into cutting income tax rates dramatically—something that Harding and Mellon set out to accomplish in the first year of the administration. In a speech before a joint session of Congress on April 12, 1921, Harding declared: “I know of no 32

The Origins of Republican Tax Policy more pressing problem at home than to restrict our national expenditures within the limits of our national income, and at the same time measurably lift the burdens of war taxation from the shoulders of the American people.”34 In November 1923, Mellon proposed a 25 percent reduction in income tax rates, reducing the “normal” tax from 4 percent to 3 percent for low-income taxpayers and from 8 percent to 6 percent for high-income taxpayers. Mellon worried that the wealthy were moving their assets into tax-exempt state bonds to avoid the 65 percent income tax surtax.35 This arrangement (which was, and remains perfectly legal, although not necessarily economically productive) could significantly lower tax bills for the wealthy, and accordingly, reduce government revenue. Mellon’s strategy of reducing income tax rates (a policy that he adopted after failing to stimulate interest in a constitutional amendment to remove the exemption for interest paid on government bonds) proved effective in expanding the tax base. When tax rates were lowered (eventually to a maximum rate of 25 percent), the incentive to purchase tax-exempt bonds decreased, capital remained in taxable investments, and government revenue actually increased. Budget surpluses were generated for the rest of the decade. During Mellon’s long tenure at Treasury, conservative tax and fiscal policy reigned supreme. Marginal tax rates were slashed, the wartime excess profits tax was repealed, a preferential rate for long-term capital gains was introduced, and the burden of the federal estate tax was significantly reduced. All this made the Republicans popular with their pro-business constituents and won them elections. Still Mellon resisted pleas from more conservative Republicans to repeal the income tax altogether, or replace it with a national sales tax—as was sought by the most conservative Old Guard Republicans (for example, Utah Senator Reed Smoot). Overall, there was remarkably little enthusiasm within Congress or the administration for repeal of the income tax. This reflected the extent to which the income tax, in less than a decade, had become so deeply ingrained in the federal revenue system, as well as the American political system itself. Mainstream Republicans were willing to accept a mildly progressive income tax coupled with an estate tax for the super-rich in order to appease the prevailing popular sentiment for wealth redistribution. Only the Old Guard conservatives still dreamed of a system of public finance based entirely on regressive consumption taxes such as the tariff or a national sales tax. Under Mellon’s tutelage in the 1920s, the strongest antitax sentiments of the Old Guard Republicans were kept in check, a federal income tax with low tax rates was retained, and still the nation enjoyed economic prosperity and budget surpluses—in short, Republican fiscal paradise! Then came the Depression, Franklin D. Roosevelt, and the end of the long era of Republican hegemony.

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Forever a Minority Party? Social unrest and a deepening sense of unfairness are dangers to our national life which we must minimize by rigorous methods. . . . Therefore, the duty rests upon the Government to restrict such [high] incomes by very high taxes. —President Franklin D. Roosevelt (1935) Hell, the way things are going now it’ll take a national catastrophe, revolution or great depression or something before we get Roosevelt out, if he lives. —Senator Kenneth S. Wherry of Nebraska (1944)

With the crash of the stock market in October 1929 and the onset of the longest and most severe depression in the nation’s history, existing political alliances were shaken apart. By 1932, there were 13 million unemployed (nearly 25 percent of the civilian workforce), most of them ill-fed, ill-clothed, and without adequate housing. The Republican in the White House, Herbert Hoover, would pay the political price for the economic crash that he was unable to reverse. Hoover had served in the Wilson administration during World War I, and subsequently, was appointed chairman of the American Relief Administration to assist in the economic restoration of Europe. Later, he was appointed Secretary of Commerce during the Coolidge administration. As Secretary of Commerce, Hoover was viewed with suspicion by the Old Guard conservatives for his efforts there at creating a professional bureaucracy and building links to private industry through state-organized trade associations. Despite that opposition, he secured the GOP nomination in 1928 when Calvin Coolidge declined to seek a second term. When the GOP assembled that June in Kansas City, Missouri, Hoover was nominated on the first ballot. He garnered 837 votes to the 74 cast for former Illinois governor Frank O. Lowden, the only other serious candidate in the race. Hoover went on to win the election by a landslide, gathering 444 electoral votes to 87 for the Democratic candidate, Al Smith. Hoover received 21,437,277 popular votes to 15,007,698 for Smith. He carried most of New England, and even won five Southern states: Virginia, North Carolina, Florida, 35

Forever a Minority Party? Tennessee, and Texas. The long era of Republican domination was not quite over yet. Herbert Hoover’s mentality was that of a bureaucrat and engineer— which he was, holding an engineering degree from the new Leland Stanford Junior University in California. In response to the economic collapse, Hoover pursued a policy of “voluntarism.” This meant meeting with trade associations, industrialists, and leaders of the financial community, trying to coax them to cooperate with the government, but always avoiding the use of the coercive powers of government to force a conclusion. Most important, the administration enacted regressive excise taxes to raise additional government revenue. Little was accomplished in this effort to reverse the declining economic situation, and perhaps the government’s fiscal and tax policies even made matters worse. The door was wide open for the Democrats in the 1932 presidential election, and they took full advantage of the opportunity.

The New Deal and the GOP In 1932, the Democratic presidential candidate, governor Franklin D. Roosevelt of New York, drew key economic and social groups out of the established Republican coalition and into the Democratic fold. Most prominently, Negroes along with ethnic and religious immigrants began to align themselves with the new Democratic coalition. This shift of voter allegiance had already begun in 1928 with the nomination of Al Smith, an urban probusiness Catholic, as the Democratic presidential candidate.1 Ironically, conservative Republicans had read the movement of urban voters to Smith in 1928 as attributable solely to his appeal to Catholic voters, failing to appreciate the depth and durability of the movement of the electorate away from the Republican party. The 1932 election saw the same forces that were set in motion by the Smith campaign creating new patterns of party affiliation, especially in the Northeast. While taking advantage of the new strength of the Democratic party among ethnic groups that had traditionally sided with the Republicans, Roosevelt was extremely careful to preserve relations with Southern conservatives, who after all still comprised one of the most important voting blocs in the Democratic party. Roosevelt successfully fended off an effort by Smith for a second run at the presidency. His tacit support for the party’s conservative platform at the 1932 convention in Chicago reflected his desire to hold together the traditional party base—at least, for the time being. The strategy paid off. Roosevelt swept the election, winning nearly 60 percent of the popular vote and 472 electoral votes to only 59 for the incumbent. Hoover had carried forty states in 1928, but could hold only six in 1932. With Roosevelt’s landslide victory in the presidential election and Democrats sweeping both houses of Congress, the Republican party found itself out of power and on the defensive. 36

Forever a Minority Party? As in most areas of domestic public policy, Roosevelt came to the presidency without any clear tax policy of his own—although income taxation had long been featured in the political platforms of the Democratic party. Progressive Democrats and Populists had always envisioned the income tax as a tool for social engineering as much as a source of revenue for the government. The radical agrarian parties viewed the progressive income tax strictly as a tool for redistributing wealth. Nevertheless, during the first two years of the new administration, the President proceeded cautiously. There was a reluctance on the part of the administration to use the income tax this way. This was at least partially based on a fear of antagonizing business and industry interests, upon whom Roosevelt believed that he depended for implementing his plan for economic recovery. In fact, at first Roosevelt tried to offset the precipitous decline in revenue under the corporate and individual income tax (attributable to the sharp decline in corporate profits and salary2) by reducing federal expenditures and increasing the regressive excise taxes enacted during the closing days of the Hoover administration—hardly what one would think of as a classic Keynesian response. At the same time, there was significant pressure exerted on the administration from those who championed a more extreme egalitarian politics. A good deal of the “thunder on the left” came from agrarian Populist Huey Long, senator from Louisiana, who advocated using the income tax to redistribute national wealth. Long’s “Share Our Wealth” plan promised to redistribute wealth taken from the super-rich under the income tax. Under the plan, every citizen would be distributed just enough to buy a modest home, car, and radio, and senior citizens would be paid an adequate pension. In the depths of the Depression, Share Our Wealth had considerable popular appeal—and not just in the South either. Long also stimulated other populist radicals (such as Father Charles Coughlin, Dr. Francis Townsend, and Gerald L. K. Smith) who made similar demagogic appeals. In fact, the income tax never could have raised enough to finance such an ambitious scheme of public spending. In Congress, the leader of the Progressives, Senator Robert La Follette Jr. of Wisconsin, proposed lowering the personal exemption by one-fifth to bring the middle class (and not just the wealthy) under the income tax. This position had considerable support among congressional Democrats. Academics too supported the notion that the middle class was not paying its “fair share.” For example, economist Henry Simons of the University of Chicago, one of the first scholars of the federal income tax, wrote that current tax rates were “absurdly low in the case of what conventional discussion strangely refers to as the lower and middle-sized incomes.”3 Simons recognized that there was just not enough income at the upper levels to equalize national wealth, as Populists such as Long proposed. Instead, the only way to raise significant money under the income tax was to bring the middle class and ordinary wealthy citizens (not just the superrich) under the tax. 37

Forever a Minority Party? Notwithstanding the conservative bent of early New Deal tax policy, it was not long before the populist “soak-the-rich” rhetoric penetrated the administration as Roosevelt succumbed to these pressures from his left. Even then, the administration continued to act as a force of moderation, as most Progressive tax proposals generally originated in Congress. Roosevelt himself still believed that he needed the support of the business community to achieve any sustained economic recovery. Under new Democratic tax legislation that came out of Congress, the Revenue Act of 1934, income tax rates for individuals were raised and the overall progressivity of the income tax rate structure was enhanced. In addition, the federal estate tax was raised to 60 percent on estates above $10 million. This was pretty much the limit to how far Roosevelt would go. In any event, a coalition of Republicans and conservative Southern Democrats was capable of blocking any more radical legislative initiatives in Congress. For the rest of the year, the administration remained passive with respect to tax policy. In 1935, Roosevelt finally took the initiative and proposed major legislation that would increase the progressivity of the income tax, increase the corporate income tax, and bring the middle class under the income tax system. Roosevelt also proposed a new federal inheritance tax—although at rates considerably lower than what La Follette sought.4 These proposals were taken up by Congress in a new tax bill that swept through Congress in less than three months, with most Democrats and very few Republicans voting for the legislation. With this new legislation, the Revenue Act of 1935, Roosevelt finally made his mark on tax policy. Even while Progressives and Populists on the left chided the President for not going far enough, Old Guard Republicans and conservative Democrats complained that Roosevelt had gone much too far. Indeed, the 1935 tax legislation provoked a severe backlash that solidified the opposition, thereby preventing any more radical proposals from reaching the floor of Congress. This is precisely what would be expected from such a “redistributive” public policy of imposing heavy (progressive) income taxes on business and high-income taxpayers in an effort to equalize wealth.5 Opposition from business interests was intense, and groups quickly organized and lobbied to block such legislative efforts. The modern “interest group” state was already in place.6 In the end, the New Deal tax legislation that was actually enacted during Roosevelt’s first term (including the most significant legislation, the Revenue Act of 1935) expressed the prevailing populist sentiments, but really made only minor structural changes to the income tax. While marginal rates on the wealthy increased throughout the 1930s, there was no significant redistribution of national wealth implemented through the income tax and inheritance tax. These taxes only imposed a modest charge on the super-rich and wealthy, while the middle class still remained largely unaffected by the income tax. In 1935, no more than 5 percent of the population was even required to file an income tax return. In addition, very little revenue was raised under the New Deal tax legislation. After the top tax rate was raised to 79 percent (on annual income above $5 38

Forever a Minority Party? million) in 1935, exactly one taxpayer (John D. Rockefeller) was subject to that maximum rate. The strategy of the New Deal Democrats was to gain favorable political publicity, and hence votes, by imposing very high tax rates on the superrich, while essentially leaving the middle class untouched. Inevitably, on account of the numerous loopholes and tax preferences built into the tax code, the superrich did not pay taxes at the exorbitant statutory rates. For these reasons, New Deal tax policy has been appropriately characterized by Mark Leff, the leading authority on tax policy during the Roosevelt years, as “symbolic reform.”7 Symbolic or not, it still was enough to make Roosevelt the most despised man in America among Old Guard Republicans and their constituents. The animosity expressed by contemporary Republicans against “tax and spend” liberal Democrats can be traced to the Old Guard’s hatred of the 1935 tax legislation. The election of 1936 reaffirmed the new coalition of interests behind the New Deal. In truth, the midterm congressional elections in 1934, in which the Democrats picked up seven seats in the House and nine in the Senate, had already foreshadowed the strength and permanency of the realignment of the party system. The Old Guard contingency from the Eastern states was particularly hard hit, losing some of its strongest leaders—such as David Reed of Pennsylvania. Until 1934, Pennsylvania was a stronghold of conservative Republicanism, but it too moved toward the Democratic party in that crucial election. In the words of historian William Leuchtenburg: “the [1934] elections almost erased the Republican party as a national force. They left the G.O.P. with only seven governorships, less than a third of Congress, no program of any substance, no leader with a popular appeal and none on the horizon.”8 In short, this was the low point of the Republican party since its inception in 1854. Stripped by time of its spiritual connections to Lincoln and his Civil War mission (which up until then held the votes of African-Americans in the North within the Republican coalition), in disrepute for its association with the Old Guard economic and tax policies of the 1920s, the Republican party could no longer offer any compelling justification for its existence. Thrown totally on the defensive, Republicans were left responding to the New Deal agenda as it was set by the Democrats. In some respects, the most rational strategy for Republican leaders to pursue after the 1934 electoral debacle would have been to move to the left (or at the very least, toward the center) and embrace the New Deal. Obviously, that was where the voters were. But it is not so easy for a minority party to redefine itself at will for such mundane and instrumental purposes as winning elections. This is especially the case where the party previously was the majority party for many decades. Parties are made up of activists who actually believe in their principles and goals. Certainly they did when the Republicans were the perennial majority party. The Old Guard was still in control of the GOP, and the Old Guard simply was not going to imitate or pander to the New Deal supporters. The idea of aping New Deal tax policy was anathema to the Old Guard and their constitu39

Forever a Minority Party? ents, even if it would have meant more favorable results in the coming elections. Their strategy, which perhaps appears shortsighted in retrospect, was to wait out the New Deal, just as they had with the Progressive insurgents who challenged them and their hold on the party in the early 1900s. In that case, they had been right—at least, to the extent that the Progressive movement died out and Republican voters eventually did return to the conservative fold. Beyond commitment to principles, there are important economic interests that support every political party, and they are not always so interested in switching horses in midstream. In an insightful study of the Republican party during the New Deal, historian Clyde Weed evaluates the options available to party leaders during the critical period of realignment from 1932 to 1936. Those options were limited by the hostility that key interest groups would have expressed toward any move by Republicans to embrace the ideals of the New Deal. As Weed puts it: “While parties must act to maximize electoral support, they have to do so in a fashion that does not lose the support of key interest groups.”9 Thus, there is a limit to how far party leaders can go in reshaping a party’s platform in an instrumental effort to garner greater voter appeal. Weed also stresses that party leaders have only limited knowledge available at any given moment for guiding them in assessing the current status of the electorate. “[T]he fate of the GOP was sealed not so much by an unwillingness to act in a Downsian [i.e., rational, vote-maximizing] fashion as by the inability of Republican leaders to comprehend what was actually occurring during the period.”10 In retrospect, the actions of the GOP leadership may appear shortsighted. But that evaluation is based on our knowledge of the history of the Republican party repeatedly losing elections over the next sixty years—an insight that the party leadership of the 1930s most assuredly did not possess. Choosing electoral strategies in the dark is considerably more difficult than writing history. Of course, it still remains to explain why Republican leaders would persist with much the same strategies after sixty years of political history spent mostly as the subordinate minority party. If the faulty strategy of 1934 may be excused for lack of knowledge at the time, the same kind of failure will be much harder to justify after the November 2002 midterm elections. In the months leading up to the November 1936 election, the administration shepherded through Congress legislation that included a new tax on the undistributed profits of corporations. While the conservative Senate was able to water down the President’s proposal, what was left (enacted in the Revenue Act of 1936) still provoked a great outcry from Republicans and their business constituents. As Leff describes it: “The Revenue Act of 1936 challenged business’s most sacred prerogative, the employment of its own profits, the perceived engine of economic growth.”11 The hostility to Roosevelt in the business community grew only stronger. Many Republicans still believed that Roosevelt was vulnerable in the coming election of 1936. That summer, the GOP selected as its presidential candidate 40

Forever a Minority Party? Alf Landon of Kansas, the only Republican governor who survived the 1934 Democratic landslide. While a few viewed Landon as little more than a relic of Old Guard Republicanism, he actually was much more liberal than that, having supported a number of early New Deal projects and possessing a favorable record on civil rights based on his opposition to the Ku Klux Klan in Kansas. Landon was an old Bull Mooser who represented the best of Western Progressive Republicanism. One of his best attributes was that he was not identified with any of the factions that divided the GOP. In his campaign, Landon singled out the recently enacted Revenue Act of 1936 (which included the undistributed profits tax) for special ridicule, pledging to repeal it if elected. Indeed, Landon denounced the “soak-the-rich” tax policies of the Roosevelt administration, as well as the new Social Security retirement program.12 For his part, Roosevelt made a dramatic turn toward the left in the election of 1936, attacking the wealthy and scapegoating business. In so doing, Roosevelt attracted support from Progressive elements, and thereby squeezed out the populist demagogues on his left. To say the least, the strategy worked. Roosevelt carried over 60 percent of the popular vote cast in the election and 523 electoral votes. Landon was swamped by the New Deal tide, receiving just 8 electoral votes (and carrying only the states of Vermont and Maine). Moreover, most Democratic candidates rode on Roosevelt’s coattails in the congressional elections, and the party easily retained control of Congress. When the new Congress met in January 1937, Democrats were unable to fit all seventy-five of their Senators on the left side of the Senate chamber and were forced to sit their twelve freshmen with the Republicans.13 The GOP was virtually annihilated as a major national political party. The election of 1936 proved that 1932 was no fluke, but rather a watershed event in modern American politics. Like the election of 1896, the 1932 vote is viewed by political scientists as a “critical election”—an election in which there is a long-term realignment of the voting blocs and interests that comprise the constituencies of the major national political parties.14 Critical elections are characterized by short-lived and intense disruptions of traditional voting patterns that result in new alignments that may very well establish a new “party system.”15 They also are marked by an intensity of ideology and polarization between the two major parties. Often, third parties appear around and immediately before critical elections as blocs of voters break away from one (or both) of the parties, seek new affiliation, and eventually settle within the other camp. In the 1936 election, the realignment of the American party system that began in 1932 was reaffirmed. After 1936, the Democratic party generally became a liberal party, and the Republican party became permanently linked to the business interests behind the party. As opposed to the electoral shakeup of 1896, this time it was the Republicans who came out the losers in the realignment of voters. In the South, the one-party system controlled by the Democrats since the Civil War remained largely intact. However, in the great cities of the Northeast 41

Forever a Minority Party? and Midwest, Negroes and Jews settled into the Democratic coalition. Much the same was true for most immigrant groups. For the first time women were admitted into the local organizations of the Democratic party, and they also became staunch party loyalists. What is now referred to as “Big Labor” moved into the Democratic camp during this period. In the 1936 election, both the American Federation of Labor (A.F.L.) and the Committee (later the Congress) of Industrial Workers (C.I.O.) came out for Roosevelt. Ever since, labor unions have been among the most committed constituents within the Democratic party. Finally, the finances of the two national political parties changed dramatically in 1936.16 Whereas bankers, brokers, and manufacturers had distributed their support fairly evenly between Republicans and Democrats in 1928, and only slightly in favor of the Republicans in 1932, there was a significant shift in 1936 away from their support for the New Deal and Democratic candidates. Business threw its support behind the GOP, while labor unions and small contributors backed Democratic candidates in the watershed election in 1936. These distinct patterns of financing for the respective parties persist to this day. Most important, Roosevelt succeeded in transforming the Democratic party into a liberal party. Only on account of the distorting influence of race did Southern conservatives remain within the liberal Democratic party for almost another half century. Even still, when voting in Congress on New Deal legislation, Southern Democrats more often sided with their spiritual brethren in the GOP than the New Deal Democrats in the White House. With the ascendancy of the New Deal, the era of Republican hegemony that had prevailed since the Civil War ended and the Democrats emerged as the dominant party in the new party system. The Republicans adopted the mentality of a minority party and were forced to pursue new strategies in what turned out to be a futile effort to regain control of the institutions of government. Beyond this shift from a Republican to Democratic electoral majority, there were also long-term structural changes made to the American political system during the New Deal. Roosevelt and the New Deal radically transformed the national party system, and at the same time, the American political system.17 The national parties became centered around the executive, which itself emerged as the focal point of the new “Hamiltonian” administrative state created by Roosevelt and the Progressive liberals during the New Deal. The “Jeffersonian” system of local, decentralized parties that had prevailed for over a century was supplanted by a new national party system dominated by the executive office. Of course, this new party system depended on a strong and active President at the center of power. This role was filled by Roosevelt as no other president before or after him would. The main thrust of the New Deal political revolution was the creation of a modern administrative state to grapple with the severe economic conditions and the pursuit of social welfare policies intended to alleviate the severe and intractable poverty that afflicted so much of the nation during the Depression. The National Industrial Recovery Act, the Agricultural Adjustment Act, and the 42

Forever a Minority Party? Tennessee Valley Authority Act were all enacted during the famous first hundred days of the first Roosevelt administration. In many respects, Franklin Roosevelt was carrying on the project that his cousin, Theodore Roosevelt, had begun three decades before during the first wave of Progressive state building. With FDR’s landslide victory in 1936, Republicans were reduced to little more than a weak political minority with a power base located only in the legislature. To be sure, the Democratic majority in Congress occasionally needed the support or acquiescence of the minority party. Ironically, as the Democratic party became more of a liberal party, Progressives in the Republican party gradually moved into the Democratic camp, leaving the GOP more solidly conservative.18 Furthermore, Republicans and conservatives made something of a comeback in the area of tax policy in the wake of popular discontent with Roosevelt’s 1937 scheme to “pack” the U.S. Supreme Court with liberals and his subsequent attempt to “purge” Southern conservatives out of the Democratic party in the 1938 primaries. First, a coalition of Republicans and conservative Southern Democrats came together to pass the Revenue Act of 1938 in defiance of Roosevelt. This legislation reduced the tax burden on corporations and cut the tax on long-term capital gains for individuals. Then the GOP scored an impressive comeback in the 1938 congressional elections, picking up a net eight seats in the Senate and eighty in the House. In addition, the party ran well at the state level. The conservative backlash resurfaced the next year when conservatives in Congress pushed through the Revenue Act of 1939, which went even further than the 1938 act in restoring favored tax treatment to business and the wealthy. By 1940, New Deal tax policy was effectively halted by the conservative coalition. During World War II, the income tax was used to raise revenue for the government more than as a tool of social policy. Out of necessity, the middle class was brought into the tax system as exemption levels were significantly lowered, tax rates were increased under the Revenue Act of 1942, and “withholding at the source” was introduced under the Current Tax Payment Act of 1943.19 However, Roosevelt suffered a dramatic setback in March 1944 when Congress enacted tax legislation contrary to the President’s indications. Roosevelt vetoed the bill—the first ever presidential veto of a tax bill, which traditionally had been respected as within the exclusive domain and prerogative of Congress. Roosevelt complained that the bill was “not a tax bill but a tax relief bill providing relief not for the needy but for the greedy.” Within a week, Congress overrode Roosevelt’s veto by lopsided margins, and the Revenue Act of 1943 became law. Notwithstanding this defeat, Roosevelt went on to win a fourth term by defeating New York governor Thomas Dewey in the 1944 election. However, by then the early triumph of New Deal “soak-the-rich” tax policy was little more than a distant memory. Notwithstanding their limited success in defending the tax laws from more extreme measures during the New Deal, Republicans were forever reacting to Roosevelt, struggling just to recapture ground lost since the 1920s. Even in this 43

Forever a Minority Party? respect, they never really succeeded. The entire domestic policy agenda, not just that for tax policy, was set by Roosevelt and the Progressive Democrats, who were in full control of the Democratic party by 1936. Conversely, the principles and tenets of the Republican party (in particular, the GOP’s vision of a limited national government and an unfettered free market economy) were overwhelmed by the New Deal. During the 1930s, the forces of Progressive state building were unleashed. Notwithstanding Republican opposition, a modern social welfare state was created in the United States. Most important, the New Deal represented a concentration of political power in Washington, centered around the executive office. The United States was transformed from a system of local parties and decentralized politics into a modern bureaucratic/administrative state in which the executive is the center of political and moral authority. This New Deal expansion of federal powers was at the expense of the state governments, which traditionally had protected the public welfare under the so-called police power and exercised limited regulatory powers. In the 1930s, the national government came to regulate the health, welfare, and education of the citizenry under the guise of regulating interstate commerce. Bureaucratic agencies in Washington were created by Congress to administer these social welfare policies. Though small and understaffed by contemporary standards, these agencies were the foundation for a new social welfare state—something conspicuously absent in America up until that time. This was what the Republican party most deeply dreaded, yet was helpless to prevent. Initially, the Supreme Court blocked this use of congressional power to regulate the national economy. Likewise, the Court protested the delegation of legislative authority to the new regulatory state.20 However, by the late 1930s, the resistance of conservatives on the Court gave way and even those justices who were true embodiments of the nineteenth-century philosophy of limited national government bowed to the Zeitgeist. Chief Justice Hughes and those associate justices (such as Justice Owen Roberts) who had repeatedly overturned New Deal legislation as unconstitutional up until 1935, suddenly did their famous “switch in time” that resulted in a nearly complete capitulation to the new public philosophy in favor of unlimited government intrusion into the private sphere. Between 1937 and 1941, Roosevelt appointed seven new liberals to the Court, further solidifying his New Deal philosophy on the bench. Indeed, with the Court’s capitulation, after 1937 there was little left beyond the grasp of Congress acting under the Commerce clause.21 Once the Court abandoned its effort to hold back the advance of Progressive state building, the national government assumed an even more active role regulating social and economic affairs. Conservatives in the Republican party were relegated to the role of Cassandra— warning of the dangers of statism, offering prophecies of doom, but wholly unable to stop the seemingly inevitable concentration of power in the new centralized administrative state in Washington.22

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Forever a Minority Party? Within the Republican party, the conservative Old Guard remained committed to the ideals and vision of limited government and states’ rights. However, in the face of Roosevelt’s widespread popularity, the Old Guard was submerged even within the GOP by the popular tide in favor of the New Deal. During the New Deal, conservatives in the Republican party watched from the sidelines as the size and scope of the national state expanded beyond anything they could have imagined in their worst nightmares. Then, with the conclusion of World War II and the death of Roosevelt, conservative Republicans saw a chance to reverse the course of the New Deal, repeal Democratic tax policy, and perhaps even dismantle some portion of the new regulatory state that Roosevelt had created.

Truman and the GOP: Tax Wars Franklin Roosevelt died on April 12, 1945, and Vice President Harry S. Truman was suddenly elevated to the presidency. The Democrat from Missouri, who had replaced the incumbent vice president, Henry Wallace, in the number two slot on the Democratic slate in 1944 when party regulars deserted the vocal advocate of radical New Dealism, would soon confront a resurgent Republican Congress bent on dismantling the new liberal order. After Roosevelt’s death and the subsequent conclusion of World War II, a conservative faction with a strong antitax message emerged as the dominant bloc within the Republican party. This faction was the precursor of the modern antitax wing of the GOP. In the 1946 midterm elections, the Republican party took advantage of the electorate’s exhaustion with two decades of the New Deal and wartime controls. Truman was highly unpopular, with a Gallup poll showing that his extraordinary January 1946 approval rating of 82 percent had sunk to a mere 32 percent by election time. The Republicans played to the none-toosubtle theme of “Had Enough?” It worked. Following the midterm elections, the GOP controlled Congress for the first time since 1930. Republicans had a 51 to 45 edge in the Senate and a solid 242 to 188 majority in the House. A number of long-time New Deal legislators were defeated, and several new Republicans came to Washington (including a young Richard M. Nixon, who won a congressional seat in California). With the Republican majority, conservatives took most of the important leadership positions and committee chairs.23 Joseph Martin of Massachusetts assumed the Speakership of the House, while Charles Halleck of Indiana (Martin’s personal choice) was elected majority leader. In the Senate, Robert A. Taft of Ohio (“Mr. Republican”) controlled the conservative Republican majority through the Republican Steering Committee. Taft was the son of former Republican president and Chief Justice of the Supreme Court William Howard Taft. While he was adamantly opposed to the New Deal, Taft himself

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Forever a Minority Party? was often flanked on his right by staunch Old Guard conservatives such as majority whip (later minority leader) Kenneth S. Wherry of Nebraska. An unyielding commitment to lower taxes emerged as one of the principal tenets of the GOP after World War II, when the highest marginal tax rate stood at an historic high of 94 percent. Congressional Republicans also sought to cut government spending and limit the newfound powers that organized labor enjoyed under the new Wagner Act. During the infamous 80th Congress, the Republican majority waged war against the policies of the Democratic administration of Harry Truman—who in turn denounced the Republican opposition as the “Do Nothing” Congress.24 As soon as the first session opened, Ways and Means Committee chairman Harold Knutsen, who had proposed serious tax relief before the election, introduced a bill for a 20-percent tax cut. The administration favored a redistributive tax credit to be funded through an increase in the corporate tax rate. This set off a struggle between the Republican Congress and the Democratic administration, resulting in Truman vetoing three Republican tax-reduction bills.25 The third time, a coalition of Republicans and Southern Democrats overrode the president’s veto. The result was the Revenue Act of 1948, which lowered the maximum individual income tax rate to 77 percent. This was somewhat less than what conservatives such as Knutsen had hoped for; however, it was a clear Republican victory nevertheless. For the time being, the tide had turned in favor of the antitax wing of the GOP. Republicans and just about everyone else expected New York governor Thomas Dewey, who defeated Taft for the Republican presidential nomination, to oust the incumbent Democrat in the 1948 election. As often happens in politics, things did not work out that way. Truman won twenty-eight states for 303 electoral votes, while Dewey carried sixteen states for 189 electoral votes. South Carolina governor Strom Thurmond captured 39 electoral votes for the States’ Rights (or “Dixiecrat”) party, while Henry Wallace (running on the Progressive party ticket) won no states. In many ways, Truman’s narrow victory over Dewey in 1948, along with the return of both houses of Congress to the Democrats, reaffirmed the Roosevelt legacy. Although Truman lacked Roosevelt’s personal charisma and popularity, he proved remarkably able in using the new executive-centered administrative state in pursuit of the New Deal liberal agenda. Indeed, Truman was even more willing than Roosevelt to advance the cause of civil rights—although, conservative Southern Democrats in the 81st Congress ultimately blocked all his legislative initiatives. Likewise, despite his spirit and commitment to the New Deal economic agenda, Truman also was blocked by the Republicans in all his initiatives in the area of tax policy. The best he could do was defend the New Deal tax system against repeated Republican efforts to withdraw the Democratic tax increases of the 1930s and 1940s and reestablish a new era of “normalcy” (i.e., low tax rates) for business and the wealthy after World War II.

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Forever a Minority Party? Again reduced to a minority party, Republicans geared up for the 1952 presidential election expecting better things to come. Conservatives who were in firm control of the party since 1946, found themselves in retreat after the GOP convention. The party selected military hero Dwight D. Eisenhower, rather than Taft, as its presidential nominee. Eisenhower, who as late as January 1952 was still keeping his party affiliation a secret, accepted the GOP nomination and won the general election by a landslide. Republican congressional candidates riding on the general’s coattails picked up an additional 21 seats in the House to take a 221 to 211 majority. The GOP also retained a slim 48 to 47 edge in the Senate (which it had taken in the 1950 midterm elections).26 However, Eisenhower’s support was largely personal and certainly did not translate well into votes for other Republicans—especially conservatives. In Samuel Lubell’s apt phrase, Eisenhower represented the “revolt of the moderates.”27 However, if a Republican moderate occupied the White House, the Old Guard still controlled the GOP in Congress. True, several prominent right-wing Republicans lost their Senate races in 1952, but a number of new conservatives (most notably, Barry Goldwater of Arizona) won seats for the first time. Taft emerged as Senate majority leader of the 83rd Congress, and Old Guard conservatives dominated the committee chairs. Likewise, the House was dominated by conservatives. Joseph Martin continued as Speaker, and Charles Halleck again won approval as majority leader. Former Cornell football coach, Daniel A. Reed of New York, took control of the Ways and Means Committee and immediately proposed income tax cuts for individuals and the elimination of the excess profits tax for corporations. This triggered a confrontation between the Eisenhower administration and the Old Guard Republican leadership of Congress. A rift between Taft and the President also erupted over the budget and foreign policy. Just as they did during the Truman years, the Republican Right Wing (typically joined by conservative Southern Democrats) played an obstructionist role during Eisenhower’s first term. For their part, conservatives were still bitter at Taft’s defeats within the party in 1948 and 1952, and never truly acquiesced in the leadership of either Dewey or Eisenhower. The result was an uneasy relationship between the GOP congressional leadership and the White House. Not much in the area of tax policy was accomplished, either. In his 1954 State of the Union speech, Eisenhower proposed postponing all remaining tax cuts scheduled under the Revenue Act of 1948. He also proposed a major effort to rewrite and codify the income tax laws. The latter resulted in the most significant tax legislation enacted to that date, the Revenue Act of 1954.28 That revenue bill codified under the Internal Revenue Code of 1954 decades of legislation and judicial “glosses” on the tax statutes. In June 1953, Taft had made an unexpected departure from the Senate. He subsequently died the following month. With that, the Right Wing suffered a

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Forever a Minority Party? severe blow and a taste of things to come. GOP candidates running for reelection in the 1954 midterm congressional elections made a poor showing, and the Republican party lost control of both houses of Congress.29 With this crucial loss, the conservative antitax wing of the GOP was reduced to a minority faction within a minority party, and thereby dispatched to the periphery of American politics. Even when Eisenhower won a second resounding victory over Democrat Adlai Stevenson in his 1956 bid for reelection (carrying 41 states for 457 electoral college votes compared to Stevenson’s seven states and 73 electoral votes), Republicans were unable to regain control of either the Senate or the House. The fate of the GOP for the next four decades was sealed. Eisenhower’s second term was marred by continued infighting between conservatives and the administration. The Right Wing denounced Eisenhower’s moderation as “Me-too” Republicanism. The president’s 1957 State of the Union address and spending levels in his budget triggered a virulent outcry from conservatives, who proclaimed Ike no better than Truman. While the revolt was strongest in the House, the junior Senator from Arizona gave the harshest assessment of the Republican president. In an April 1957 speech from the floor of the Senate, Barry Goldwater charged that Eisenhower had been lured by “the siren of socialism” and that his administration merely “aped the New Deal.”30 The Old Guard, which always opposed compromise and accommodation with the New Deal, had a new and eloquent spokesman, and the rift within the GOP between moderates and conservatives festered. This did not help the party at the polls. In the 1958 midterm elections, Republicans suffered their worst loss since Roosevelt’s sweep in 1936. After the dust cleared, Democrats held a 64 to 34 edge in the Senate and a 282 to 154 majority in the House. Most of the Old Guard that had been elected to Congress in the great Republican victories of 1946 and 1952 either retired or were cast out of office. Those few left were marginal in the party. Goldwater surfaced as the leader of what was left of the conservative movement, while the newly elected governor of New York, Nelson Rockefeller, emerged as the leader of a revitalized liberal wing of the GOP. The 1958 midterm elections signaled what was in store for the GOP, as well as the conservative movement. The Old Guard, tainted by the legacy of isolationism and McCarthy and without the leadership of Taft, lost their hold on the party. On the other hand, Eisenhower succeeded in drawing some new voters into the Republican party in the South. This trend continued throughout the 1970s, and Southern states would eventually emerge as a solid voting block in the Republican party in the 1990s.31 However, for the time being Republicans were still the opposition party in Congress. For the next forty years, despite winning five presidential elections, the GOP continually played second fiddle to the Democrats in Congress. The role of the Republican party during this period has been likened to that of the “moon,” dwarfed in comparison by the dominate “sun” party (the Democrats) that controlled the national political arena.32 Needless to say, in Congress, as everywhere else, it is better to be the sun than the moon. 48

Forever a Minority Party? The Great Society Swamps the GOP If conservative Republicans languished in Congress after 1954, that was nothing compared to what they suffered in the 1960s. After the 1960 presidential election in which Democrat John F. Kennedy squeaked by the Republican candidate, former Vice President Richard M. Nixon, things went downhill for the GOP. The 1962 midterm congressional elections marked the turning of the tide against the Republicans, as Democrats retained a 259 to 176 hold on the House and seized a commanding 68 to 32 majority in the Senate. Then in the 1964 presidential election, the GOP candidate suffered one of the worst thrashing in U.S. electoral history. Vice President Lyndon B. Johnson had ascended to the presidency in November 1963 upon the assassination of Kennedy, and within months shepherded through the Democratic Congress what was at the time the largest tax cut in American history. The Revenue Act of 1964 cut the maximum marginal tax rate from 91 percent to 70 percent (a rate reduction of 23 percent), where it remained until the Reagan tax cuts of the 1980s. The lowest tax rate was reduced from 20 to 14 percent; middle-income rates were reduced somewhat less. Ironically, the greatest success in enacting broad-based tax reduction in the postwar era belonged to the Democrats, rather than the antitax wing of the GOP. This significant tax cut would later inspire a generation of Republican supply-side economists in the 1980s. If Johnson supported the 1964 tax cut, he also was deeply committed to the New Deal tradition of social welfare policy. Likewise, he was staunchly dedicated to the emerging Civil Rights movement—perhaps even more so than Kennedy. Only six weeks before his nomination that summer at the 1964 Democratic convention in Atlantic City, Johnson pushed Congress to enact the Civil Rights Act of 1964. That legislation effectively declared unconstitutional the system of de facto segregation that prevailed in the South since the days of Jim Crow. (After the election, Johnson went even further, throwing his weight behind national civil rights voting legislation. Standing before a joint session of Congress in March 1965, Johnson declared, “We shall overcome,” and finally drove conservative Southern whites out of the unwieldy and overextended Democratic coalition.33) Negroes in the North and South began to register to vote in record numbers for the 1964 election, and most settled in the Democratic party. The Northern liberal wing controlled the Democratic party, now firmly committed to civil rights legislation and social welfare policies.34 In the end, this may have provoked the Republican Right Wing, which generally opposed federal civil rights legislation, and led to a showdown in the 1964 election between Johnson and post–New Deal liberalism, on the one hand, and the modern embodiment of conservative Republicanism, Arizona Senator Barry Goldwater, on the other. To say the least, post–New Deal liberalism won that confrontation. 49

Forever a Minority Party? For all practical purposes, Goldwater’s presidential campaign began in 1960 with Richard Nixon’s loss to Kennedy. When Nixon subsequently lost to incumbent Democrat Pat Brown in the 1962 governor’s race in California and temporarily withdrew from public life (admonishing reporters that “you won’t have Nixon to kick around anymore”35), Goldwater emerged as the frontrunner for the 1964 GOP nomination. Goldwater’s conservatism was a hardheaded mix of Old Guard Republicanism, antistatism, states’ rights, and right-wing anticommunism. In his 1960 surprise best-seller, Conscience of a Conservative, Goldwater expressed an equally strong hostility to big government in both Washington and Moscow. He rejected national civil rights legislation as a violation of states’ rights and overextension of the powers of the federal government (and accordingly, voted against the Civil Rights Act of 1964). He also denounced the progressive income tax as “repugnant to my notions of justice.”36 There was no clearer statement of conservative Old Guard principles in the second half of the twentieth century. But was such a conservative platform the right strategy for the modern Republican party? How Goldwater captured the 1964 Republican presidential nomination is a story in itself.37 In the primaries, he made a poor showing. In New Hampshire, despite support from right-winger William Loeb, the powerful and influential publisher of the Manchester Union-Leader, Goldwater barely squeaked by liberal Republican Nelson Rockefeller, who was waging an on-again, off-again campaign for the GOP nomination. Rockefeller’s recent divorce and Northeastern brand of liberal Republicanism doomed his candidacy. It is sufficient to say that through some luck and skillful maneuvering at the convention, Goldwater and the Right Wing eventually captured the nomination, beating out on the first ballot his only serious challengers, Pennsylvania governor William Scranton (a self-declared “Progressive Republican”) and Michigan’s George Romney (a moderate). In 1962, both had won impressive electoral victories in important states, briefly putting them in the national spotlight as potential GOP presidential candidates. But both failed to generate sufficient support among Republican moderates and liberals to stop the Goldwater juggernaut. At the convention, Goldwater was nominated by California governor Ronald Reagan. The right-wing presidential nominee then broke with tradition. Rather than try to balance the party ticket, he selected another conservative, New York congressman William E. Miller, for the vice presidential slot. Goldwater’s own acceptance speech expressly repudiated any possibility of accommodation with the party’s liberal wing: “Anyone who joins us in sincerity we welcome. Those who do not care for our cause, we do not expect to enter our ranks in any case.”38 Later, in a televised speech in October 1964 on behalf of the Goldwater candidacy, Reagan established his own credibility as a leader of the Right Wing of the GOP. Reagan warned against the threat of creeping socialism, which he equated with increased government regulation of business: “It is time we realized

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Forever a Minority Party? that socialism can come without overt seizure of property or nationalization of private business. It matters little that you hold title to your property or business if government can dictate policy and procedure and holds life and death power over your business.”39 Clearly, Goldwater and Reagan were on the same page. If Goldwater was successful in maneuvering to gain the Republican party nomination, he proved less skillful in attracting voters in the election itself. Some unfair and morally questionable political ads from Democrats (and their supporters) coupled with popular fear of the unknown certainly worked against Goldwater. In the end, Johnson won 61 percent of the popular vote (the largest plurality in history), carrying 44 states and 486 electoral votes compared to the six states and 52 electoral votes that Goldwater carried. Johnson’s trouncing of Goldwater was accompanied by a Democratic sweep of Congress that resulted in lopsided majorities in both the House and Senate. The 1964 electoral results reaffirmed in the strongest terms the realignment of the electorate and party system that began in 1932 and made the Democratic party the dominant party. With Goldwater’s sound defeat, the conservative Right Wing of the GOP was left in full retreat. After the 1964 congressional elections, Democrats held a 68 to 32 majority in the Senate (the largest since 1943) and a 295 to 140 majority in the House (the largest since 1939). During the subsequent years when Republicans were a minority opposition party in the legislature, the antitax wing of the GOP was submerged by the moderate center as well as the liberal Northeast wing (personified by Rockefeller and New York City mayor John Lindsay), which tacitly accepted the basic premises of the post–New Deal political order. Those conservative Republicans in Congress still ideologically opposed to such staples of the modern state as the progressive income tax, welfare programs, and Social Security, were relegated to the back benches, reduced to outsiders in their own party. Republicans in general were unable to resist the broad expansion of the role of the national government orchestrated by Democrats during the Johnson years. Lyndon Johnson’s Great Society program consisted of the expansion of the social welfare programs that originated with the New Deal. The original Social Security program was expanded in 1965 with the adoption of a new Medicare program for the aged. In 1965, through amendments to the Social Security Act, Congress created a new social welfare program for the poor—Medicaid. At the same time, Johnson waged his “War on Poverty,” with its Community Action Program and the Head-Start program for preschool children of the disadvantaged. As previously mentioned, he shepherded through Congress the Civil Rights Act of 1965. During his administration, the Department of Housing and Urban Development (1965) and the Department of Transportation (1966) were established. The functions of the Department of Education were enhanced with the expansion of the National Defense Education Act and the enactment of new legislation, the Elementary and Secondary Education Act of 1965. The new

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Forever a Minority Party? agencies and domestic policy programs of the Great Society expanded the American state created during the New Deal and broadened the scope of its regulatory powers. The impotence of the conservative Right Wing (and Republicans generally) in challenging the expansion of the social welfare state is perhaps best illustrated by the disastrous effort of conservative GOP presidential candidate Barry Goldwater to question the basic premises of the Social Security program— the most prominent and entrenched of all New Deal social welfare programs. Created in 1935 and allegedly Roosevelt’s favorite program, Social Security emerged as the nation’s most successful, popular, and costly domestic public policy. Social Security became so popular over the decades subsequent to its creation precisely because the benefits of the program are so widely dispersed. Virtually every citizen of the United States—as well as those alien residents who work in the United States for the requisite number of years—qualify for Social Security retirement benefits. The wide dispersal of benefits and the relatively hidden (and for most of the history of the program, relatively modest ) costs of the program (which was originally funded by a 2 percent payroll tax that remained as low as 3 percent as late as 1950, and 6 percent in 1960) guaranteed strong and deep popular support for the program. Despite initial objections to the program when it was enacted in 1935 during the early days of the New Deal, conservative opposition had fallen silent during the subsequent decades in the face of the overwhelming popular support for the program. Indeed, Social Security was widely viewed by political analysts as the “Third Rail” of American politics—purportedly conferring certain political death on any politician so foolish as to challenge the reigning orthodoxy. In a speech on the campaign trail for the New Hampshire primary, GOP presidential candidate Goldwater raised what in retrospect sounds like a rather tame challenge to the Social Security program. Goldwater suggested “one change” in Social Security—that it be made “voluntary . . . if a person can provide for himself, let him do it.”40 Of course, allowing the wealthy to “opt out” of Social Security would threaten the financial integrity of the entire program, so this was not really such an innocent suggestion. Still the public reaction (stimulated by the print and television media, as well as Democrats both in and outside the Johnson campaign) was entirely overblown. In 1964, Social Security was viewed by the electorate and politicians alike as sacrosanct. Those moderates within the GOP who actually wished to win the election, rather than just pursue “virtue” with extremism, shuddered when Goldwater challenged the sacred cow of liberal Democrats. Liberals responded with a smear campaign of innuendos based on the premise that Goldwater would be too quick to push the trigger on nuclear weapons. In an unseemly exercise in pop psychologizing, some in the news media questioned the very sanity of the Arizona Senator.41 The popular reaction to Goldwater was also negative. It is an understatement to say that the

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Forever a Minority Party? American electorate did not respond favorably to Goldwater’s campaign against the liberal establishment. Goldwater’s politically doomed challenge to Social Security was one of the few serious attempts to question the legitimacy of the New Deal social welfare state since the Republican party relinquished control of Congress after the 1954 elections. After Goldwater’s thrashing in 1964, the only remaining protests against the Great Society social welfare programs came from the right-wing fringe, such as Robert Welch and his John Birch Society. With Johnson’s victory in 1964, the new social welfare state seemed so well entrenched as to be unshakable. Ironically, Goldwater’s defeat in 1964 also triggered the demise of the liberal wing of the GOP. Owing to a combination of conservative dominance of the party in the early 1960s and the “foibles” of their own leadership, the liberal wing of the GOP self-destructed and virtually disappeared from the political scene within a decade of the Republican debacle of 1964.42 What was left of the Republican party was a weak moderate center and the conservative Right Wing.

Lost Decades for the GOP In the 1966 midterm elections, Republicans made significant gains in the House and Senate, as well as at the state level (winning eight governorships). However, this was not a great success for conservatives. Even when Republicans regained control of the White House in 1968 with the election of former Vice President Richard Nixon, conservative opposition to the expansion of the state administrative apparatus was ineffectual. Nixon won the presidency in a close contest against Vice President Hubert Humphrey (capturing 31.79 million votes to Humphrey’s 31.25 million), but Democrats retained control of both houses of Congress. When Nixon affirmatively supported the creation of entirely new regulatory administrative agencies (such as the Environmental Protection Agency) as well as imposed wage-price supports in 1972 (only two years after blocking efforts by the Democratic Congress to implement the same), the conservative attack on the modern American state was stymied. Only deteriorating economic conditions during the 1970s prevented further expansion of the American social-welfare regulatory state. During this period, the leaders of the minority party in Congress were mostly centrists who were content with the occasional special tax provision implementing some policy favorable to Republican interests or bestowing targeted tax relief to some important constituents within the Republican party. This was gained through bipartisan cooperation on the two committees of Congress that write tax legislation—the House Ways and Means Committee and the Senate Finance Committee. During the 1960s and 1970s, it was senior Democrats on the tax committees who wrote the tax laws. They used that power to secure

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Forever a Minority Party? special provisions for constituents in their districts, as well as provisions for the important organized interests within their national party coalition—e.g., organized labor, the education establishment, farmers, minorities, and low-income taxpayers. However, in tax policy, as with everything else in Washington politics, those who go along, get along.43 For those senior Republican members of the tax committees who cooperated with the Democratic majority, special tax provisions were occasionally granted in reciprocity. This is part and parcel of the political system of bargaining, logrolling, and nonpartisan constituency service (all within the context of a Democratic controlled Congress) that produced the modern tax code—with all its economic distortions, special interest provisions, and mindnumbing complexities. In such a political system, there are few incentives for politicians (whether Democrat or Republican) to reduce taxes once in office. True, tax cuts can make for a compelling campaign issue during an election (again, for Democrats as well as Republicans). Republican strategists seem to believe that a plan of tax cuts is the only successful campaign theme for Republican candidates running in a popular election. Opinion polls and recent political experience, especially at the presidential level, cast considerable doubt on this strategy. In any event, tax cuts are hardly ever in the self-interest of politicians holding office in Washington. Tax revenue is the mother’s milk that supports all the domestic policy programs that politicians propose, and politicians (as opposed to ideologues) are reluctant to cut off the source of their own sustenance. For the last eighty years, the principal source of revenue of the federal government has been the income tax. The revenue from the income tax financed the broad expansion of government functions during the twentieth century—to say nothing of funding U.S. involvement in two World Wars and several major regional military conflicts in Southeast Asia and the Persian Gulf. New federal programs and increased spending requires increased tax revenue, and mainstream Republicans and virtually all Democrats have been disinclined to cut back the principal source of that revenue. During the postwar decades when Democratic majorities controlled Congress, the Republican establishment generally accepted the basic principle that the expansion of government programs was, if not actually desirable, at least inevitable, and would be funded by increased taxes—mostly derived from the income tax, but also from the Social Security payroll tax. Indeed, income tax increases came easy in the 1960s and 1970s—a period aptly described as an era of “easy finance.”44 The rampant inflation of the period provided politicians with the equivalent of nonlegislated, automatic tax increases as inflated wages pushed taxpayers into higher tax brackets, thereby subject to higher tax rates. During an inflationary period, workers who do not actually earn greater wages in economic terms pay more in taxes to the government. With this in mind, economist Milton Friedman once quipped: “Inflation is taxation without legislation.”45 At the same time, the basic operating principle of politicians in Washington is to enact special tax provisions granting relief from such taxes to important organized interests in 54

Forever a Minority Party? both parties. As a result, the fundamental characteristic of the federal tax code in the 1960s and 1970s was high marginal rates and countless special provisions granting “targeted” tax relief to special interests. Ironically, American national politics produced a fairly stable, albeit flawed tax policy during this period. Democrats controlled the tax committees and the legislative process, and tax policy evolved through a process of “incremental” development. Political scientist John Witte, writing in 1985, described U.S. tax policy as “an incrementalist paradise, susceptible and seductive to political tinkerers. As a result, most changes in tax bills consist of simple adjustments in existing policy provisions.”46 Furthermore, tax policy was highly susceptible to interest group pressure during this period. A significant number of provisions were added to the tax code to bestow special treatment on well-organized economic and social interests that successfully lobbied those policymakers who sit on the tax committees of Congress, both Democrats and Republicans alike. For this reason, tax policy has been appropriately described by reference to a “pluralist/ incremental” model.47 This descriptive model of tax policy was, and still remains quite accurate with respect to explaining a significant portion of federal tax policymaking. However, while much tax policymaking consists of nonpartisan constituency service implemented through incremental changes to the tax code, a significant portion reflects the ideology and principles of the majority party that controls the tax policymaking process. In other words, a majoritarian model is also descriptive of much of federal tax policymaking. Because of this, a good deal of the tax code reflects the interests and preferences of the Democratic party, which generally controlled the legislative process, and very often the White House, during most of the postwar era. True, the Republican party enjoyed a revival between 1946 and 1954, and the GOP briefly challenged the majority party’s hold on the federal government. But the conservative Republicans who controlled the 80th Congress were unable to reverse the overall direction of federal policymaking, in particular with respect to tax policy. They mostly ended up in deadlock with the Truman administration. Conservatives in Congress fared little better with the moderate Republican Eisenhower administration. After that, they were submerged altogether by the overwhelming majority that the Democratic party enjoyed during the 1960s and 1970s. That is when the long period of stable, incremental tax policymaking was at its peak. That is when the pluralist/ incremental model was most descriptive of the development of the tax code. The tax code produced by this pluralist/incremental policymaking eventually became overly bloated and ripe for reform. For this reason, it emerged as the favorite whipping boy of politicians of all persuasions—not just antitax conservatives in the GOP. Indeed, virtually every president since John F. Kennedy has initiated proposals for “tax reform.” In 1962, Kennedy called for reform “aimed at simplification of our tax structure, the equal treatment of equally situated persons, and the strengthening of incentives for individual effort and 55

Forever a Minority Party? productive investment.”48 Richard Nixon announced in 1969: “We must reform our tax structure to make it more equitable and efficient; we must redirect our tax policy to make it more conducive to stable economic growth and responsive to urgent social needs.”49 Later, Democratic President Jimmy Carter declared: “It’s time for a complete overhaul of our income tax system. I feel it’s a disgrace to the human race.”50 Of course, politicians from the two political parties have very different notions of what it means to reform the tax code. Notwithstanding the growing interest in tax reform, during the 1960s and 1970s the tax code itself became ever more complicated and loaded with special interest provisions dedicated to constituents of both political parties. During this period, Republicans in Congress were again submerged by the Democratic majority. They simply were unable to find the right message or campaign strategy to elevate them from their prolonged status as a minority party. Furthermore, conservatives were relegated to the margins within the GOP itself. Then the former governor of California, Ronald Reagan, captured the Republican presidential nomination, and the Right Wing again emerged in control of the party. The GOP found its conservative voice and antitax message. It is only within the context of twenty-five years of domination by the Democratic party that Reagan’s landslide victory in 1980 can be most fully appreciated.

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3

Reagan Changes the Course It is my intention to curb the size and influence of the federal government and to demand recognition of the distinction between powers granted to the federal government and those reserved to the states or to the people. All of us need to be reminded that the federal government did not create the states; the states created the federal government. —President Ronald Reagan (1981) Let us go forward with an historic reform for fairness, simplicity and incentives for growth. I am asking . . . for a plan for action to simplify the entire tax code, so all taxpayers, big and small, are treated more fairly. —President Ronald Reagan (1984)

In the mid-1970s, the conservative movement in the United States experienced a revival of sorts, giving a timely boost to the fortunes of the Republican party. Socalled New Right social conservatives organized, and new groups representing their interests sprang up across the country. These single-issue grassroots interest groups, organized around such themes as opposition to abortion, crime, and gun control, eventually coalesced around the Republican coalition. Within a short time, the Moral Majority and other Christian-based movements became powerful constituents within the GOP. While not entirely at home in the Republican party of the 1970s, they essentially had nowhere else to go in the political arena with their agenda for school prayer, education vouchers, tax benefits for families, and opposition to gay rights and most of the secular values of modern “liberal” society. In the end, they cast their lot with the Republican party, supporting the conservative candidate who ran for the presidency in 1980. While the Republican party moved to the right, the moderate center in both major national parties weakened. Not only did the liberal wing of the Republican party virtually disappear during the 1970s, but the moderate center also declined dramatically. On the other side of the aisle, the Democratic party moved toward the left as Southern conservatives abandoned the party over the 57

Reagan Changes the Course issue of civil rights. This reshuffling of Southern conservatives into the Republican fold created greater unity within each party and greater polarity between the two parties. This trend was evidenced in a number of ways. For instance, after the mid-1970s, there was a discernable decline in the number of roll call votes in Congress in which there was significant division within each party—a much more common phenomenon in the years from 1945 to 1975.1 This ideological unity within the parties was accompanied by an increase in the tension between them, as the Republicans drifted to the right and the Democrats to the left. The polarization within the congressional parties reflected a similar trend at the level of congressional districts, a greater number of which became either uniformly liberal or conservative, with fewer a competitive mixture.2 With the parties more clearly defined ideologically, the ground was laid for the conservative Right Wing of the Republican party to reassert itself first within the GOP, and then within the national party system.

The Reagan Revolution After giving an electrifying nominating speech for Barry Goldwater at the 1964 Republican convention, former movie star Ronald Reagan emerged as a prime contender for the GOP presidential nomination sometime in the near future. In 1966, Reagan took the first step by running for governor of California. Surprisingly, he defeated the incumbent Democrat Pat Brown by over a million votes. Immediately after the election, Reagan and his supporters looked toward the White House.3 Blocked in his quest for the presidency by Richard Nixon in 1968 and 1972, Reagan made an ill-fated bid to seize the GOP nomination from Gerald Ford in 1976. Ford, a moderate Republican and former House minority leader, had been appointed vice president by Richard Nixon following Spiro Agnew’s resignation from that office in 1973. He then ascended to the presidency in August 1974 upon Nixon’s own resignation under intense pressure during the Watergate investigation. The chance of Reagan dethroning the incumbent Republican president in the primaries was a long shot, at best.4 Nevertheless, Reagan ran as a conservative bidding for support from social conservatives and the Right Wing generally. He fared poorly in the New Hampshire primary, and then was trounced in Florida. Like Goldwater before him, Reagan made some politically ill-advised statements about the viability of Social Security. These surely contributed to his loss in Florida, where senior citizens are an important voting bloc. While Reagan subsequently won primaries in North Carolina, Texas, Indiana, Alabama, and Georgia, it was too little, too late. Ford captured the GOP nomination, and Reagan went home to California. However, he had made his point. After Ford and his running mate, Senator Robert Dole of Kansas, were trounced in the

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Reagan Changes the Course November election by Democrat Jimmy Carter of Georgia, Reagan was positioned as the frontrunner for the 1980 campaign. The big question was whether the GOP would again nominate a conservative, given Goldwater’s dismal performance in the general election. In 1980, with Ford out of the way, Reagan betrayed little hesitation in going after the nomination. In the GOP primaries, Reagan faced a host of candidates in a crowded field. Congressman Phil Crane of Illinois, another conservative candidate vying for support from the New Right, made an early effort in the primaries, but quickly dropped out. Then Reagan defeated George Bush in New Hampshire, John Connally in South Carolina, and John Anderson in Illinois. One by one these candidates also dropped out of the race, and Reagan was left as the leader of the Republican party as well as the conservative movement. For the second time in sixteen years, the GOP nominated a conservative from the party’s Right Wing to run for president. However, Reagan began his run for the White House from a more favorable position. Unlike Goldwater, Reagan had the full support of his party behind him following the nominating convention. Furthermore, Jimmy Carter was not widely popular with the electorate, as had been Lyndon Johnson in 1964. Likewise, the Democrats themselves were far from united behind Carter, as they had been for Johnson. Massachusetts Senator Edward Kennedy had challenged Carter in the primaries, and although he and his liberal faction lost the contest, the Democratic party was left badly divided by the intraparty squabble. Carter’s support with voters was also weakened by unfavorable events in Iran and Afghanistan, and at home, by soaring inflation and economic stagnation (“stagflation”). The president’s inability to cure the domestic “malaise” that he himself diagnosed as a national affliction virtually invited voters to try another candidate. In the general election, Reagan faced off against Carter and independent third-party candidate John Anderson in a three-way race. Seldom has an incumbent president fared so poorly in a bid for reelection. In an election in which voter turnout was extremely low, with the participation of only 52 percent of the eligible voters, Reagan won handily. He carried 44 states and took 489 electoral votes. The Old Guard had elected its first president in over fifty years, defying the conventional wisdom that a conservative could win the GOP nomination, but never a general election. Republicans also picked up a net 13 seats in the Senate to claim their first majority there since 1954. While Republicans in the House remained a minority, they did gain a net 33 seats, leaving the Democrats with a reduced 243–192 margin (compared to the whopping 277–158 margin they had held prior to the 1980 elections). A solid contingent of conservative Southern Democrats gave the new administration additional support in the House. With Reagan’s impressive electoral triumph and these important gains in Congress, conservative Republicans were as close to the center of government as they had been in decades. What is more, the antitax wing of the GOP enjoyed a reprieve,

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Reagan Changes the Course as well as the first real opportunity to influence domestic policy since the 80th Congress. Reagan and the conservative Right Wing made the most of the opportunity. Reagan came to office deeply committed to three issues: building up U.S. military forces, reducing the size of government as well as government spending, and lowering taxes. He immediately took up the issue with the best chance for success in the short run—tax cuts. David Stockman, director of the Office of Management and Budget during the first Reagan administration, has suggested that Reagan’s commitment to lower marginal tax rates was “one of the few things Ronald Reagan deeply wanted.”5 True, Reagan’s devotion to lower taxes was mostly rooted in his personal experiences, rather than in economics or political theory. But the same antitax mentality that possessed Reagan (admittedly not an economist, political philosopher, or deep thinker of any kind) now permeated the rest of the Republican party. In some cases, this antitax mentality was dressed in slightly different garb and somewhat more sophisticated intellectual trappings, but always it was Reagan who set the tone for his administration. Reagan was deeply committed to the Republican credo of antistatism and decentralized federalism. His antitax philosophy complemented both these positions. In his First Inaugural address, Reagan took direct aim at the post–New Deal order. He warned of the dangers of overreliance on public solutions to social ills: “In the present crisis, government is not the solution to our problem; government is the problem.”6 He then reiterated his commitment to reducing the size of the government in Washington: “It is my intention to curb the size and influence of the federal government and to demand recognition of the distinction between powers granted to the federal government and those reserved to the states or to the people. All of us need to be reminded that the federal government did not create the states; the states created the federal government.”7 So the main goals of the new administration in domestic policy would be to reduce the size and scope of government in Washington and cut taxes—two closely related policies. While he never got very far in reducing the size of the federal government, Reagan wasted no time in securing his tax cut. During the 1980 presidential campaign, Reagan had endorsed in principle a tax-rate-reduction proposal originally introduced in 1977 by Senator William Roth and Representative Jack Kemp. The “Kemp-Roth I” proposal called for a 33 percent reduction in the tax rate for individuals and a reduction of 3 percentage points in the corporate rate. In the spring of 1981, the new president introduced his own legislative proposal for somewhat more modest tax rate reductions styled on Kemp-Roth. Reagan’s proposal ran into stiff opposition in Congress. After all, the House was still controlled by the Democrats, and Republicans in the Senate were not so keen on a major tax cut. However, by midsummer 1981 the “Great Communicator” was able to bring together a bipartisan congressional coalition behind a massive tax reduction proposal. Conservative Southern Democrats (the remnants of the old “Boll Weevil” faction), as well as a few 60

Reagan Changes the Course moderate Democrats, supported the President’s initiative for tax reduction. In August, the campaign bore fruit with enactment of the Economic Recovery Tax Act of 1981 (ERTA).8 While the ERTA tax cuts were less than those prescribed under Kemp-Roth, as well as less than what the President originally proposed, they still constituted the most significant tax rate reduction in the history of the federal income tax.9 The legislation reduced taxes not only for individual taxpayers (for whom the maximum rate of 70 percent was lowered to 50 percent), but also for corporate America. Following the ERTA tax cuts, the share of federal receipts derived from the corporate income tax sank to a postwar low of 6.2 percent. The 1981 legislation has often been cited as an example of how Congress loads up tax and revenue bills with all sorts of special interest provisions and other “anti-reform” measures.10 Much has been written about the unusual competition and resulting “bidding war” that led to the inclusion of countless probusiness tax benefits in the final legislation. According to one account of the 1981 tax initiative, “his [Reagan’s] initiative sparked a ‘bidding war’ between the White House and Capitol Hill as legislators from both parties sought political favors by offering new tax breaks pleasing to their constituents.”11 Of course, some of the provisions favorable to business could be justified from the perspective of sound, rational tax policy. But most were little more than special tax preferences granted to powerful interest groups to which the Republican party owed allegiance. These were added to the package by the administration in an effort to secure support from business for the tax cuts for individuals. Included among the proposals added to the President’s bill at the various stages of the legislative process were indexing the tax brackets against inflation (which ended the “automatic” tax increases that politicians enjoyed in the 1960s and 1970s), expanded eligibility requirements for individual retirement accounts (IRAs), increased tax credits for research and development, an expanded childcare credit, a new low-income housing credit, and an election to expense $10,000 of business property annually in lieu of capitalization. Liberalized depreciation schedules under the new Accelerated Cost Recovery System (ACRS) were also included among the probusiness provisions in ERTA. The generous depreciation schedule replaced the old and contentious system of depreciating an asset over its “useful life.” The new accelerated depreciation system provided fixed and considerably shorter depreciation schedules for three categories of assets (real estate, equipment, and motor vehicles). This system was much more favorable to capital intensive industries, which threw their full weight behind the provision in an extensive lobbying campaign. A provision creating the so-called safe harbor lease was also included among the probusiness provisions in ERTA. The safe harbor lease provision was designed by tax experts and economists in Treasury to allow “loss corporations” (i.e., corporations without taxable income) to make use of the tax benefits attributable to the ownership or acquisition of business assets, such as the investment 61

Reagan Changes the Course tax credit and accelerated depreciation. It was difficult to use tax incentives to stimulate economic activity where a significant portion of corporate taxpayers had little or no taxable income. Through the ingenious device known as a safeharbor lease, the loss corporation could essentially “sell” the tax benefits to a profitable corporation that could use them to offset taxable income. With the new ACRS schedules and the investment tax credit, the new owner/lessee of the property could actually be better off for tax purposes than if the property was simply expensed in the first year of ownership. In other words, the combined effect of the accelerated depreciation and the investment tax credit created a socalled negative tax rate under which the Treasury was underwriting more than 100 percent of the cost of new capital investment via tax subsidies. An extraordinary deal for those businesses (both profitable and unprofitable) that purchased or leased qualified business property during the short-lived reign of the safeharbor lease! Corporate business interests lobbied in favor of most of these highly favorable provisions—although the safe-harbor lease was beyond even their wildest dreams. In some cases, these business interests were active participants in the legislative process.12 However, not all business interests supported each one of these provisions in the same way or to the same degree. For example, small businesses generally favor expensing (immediate deductions) for capital expenditures as opposed to depreciation. The system of accelerated depreciation does not help them as much as it does large industries with significant investments in capital facilities. As a result, small business was often pitted against big business in lobbying efforts for and against individual provisions in the bill, although all of these proposals are commonly lumped together as “probusiness” tax incentives. Considerable subtlety, skill, and care is required in separating the positions of the various interests within the business community.13 If the final ERTA tax legislation ended up including numerous probusiness provisions, its proponents initially began from the purely theoretical proposition that reducing taxes for business and individuals would stimulate investment and risk taking activity that in the long run would benefit the economy as a whole. The intellectual underpinnings for the 1981 tax cut can be located in the “supply-side” economics that held sway over conservative economic thought during the late 1970s and greatly influenced economic thinking within the Reagan administration during the 1980s. This line of thinking was particularly prominent among economists in the Treasury Department’s Office of Tax Analysis and White House staff.14 Supply-siders argued that reducing marginal tax rates would provide incentives to entrepreneurs who would create new businesses and wealth, thereby resulting in greater wealth for society. One corollary of the supply-side economics bandied about in the administration was that the increased economic activity attributable to a reduction of marginal tax rates would result in increased revenue collected under the income tax. Whether that increased tax revenue would fully offset the revenue lost from 62

Reagan Changes the Course the tax reduction was a point in dispute, even among supply-side proponents themselves.15 The position of more cautious supply-siders was that the behavioral effect attributable to the reduction in marginal tax rates would at least partially offset of the revenue lost from the tax cut itself.16 Contrary to the claim of supply-siders, traditional fiscal conservatives (such as Alan Greenspan, then head of the president’s Council of Economic Advisers) argued that the primary goal of policymakers should be to balance the budget and control spending, rather than stimulate individual incentives. Aside from the supply-side contingency, there were other Republicans committed to tax reduction. Some were located in the White House, but most were in Congress. For instance, there was the so-called proinvestment wing of the GOP. The proinvestment Republicans, led in the House by New York congressman Jack Kemp, were enamored by the notion that cutting taxes would lead to an explosion of investment and development that would not only benefit the wealthy owners of capital, but also the poor and working classes. These would enjoy greater job opportunities and higher wages attributable to the expanding economy. Lower taxes would lead to greater investment and more jobs for everyone. Their claim was that all this—prosperity, prosperity, investment, and jobs—would flow from merely reducing taxes! Kemp and the political advocacy group that he subsequently organized, Empower America, lobbied for specially designated “enterprise zones” in depressed urban areas that would test the thesis that lower taxes would spur investment and economic development. The campaign for such tax-favored geographical zones eventually bore fruit as these were inserted into the tax code in 1993 and later expanded in 1997 and 2000.17 Thus, the Republican campaign for tax reduction which began in 1946 as an attack on the Truman administration and sky-high postwar tax rates finally succeeded in 1981 during the first year of the new Reagan administration. But it was a short-lived victory. Almost as soon as ERTA was enacted, policymakers in Congress had second thoughts about the just enacted tax cuts in the wake of new and gloomy forecasts of future budget deficits. For instance, the fiscal year 1982 budget was originally projected to come in at $45 billion. Revised estimates now put it at close to $100 billion—an unprecedented figure, especially in light of the $59.6 billion and $57.9 billion deficits from the two prior years. To make matters worse, the economy went into serious recession by the middle of 1981, and the slowdown persisted throughout the following year. To the extent the deficits were the problem, either spending would have to be cut or taxes would have to be raised. Neither was an easy choice for Reagan. Reagan Retreats? The administration had been unable to reduce spending to counteract the impact of the ERTA tax cuts. Indeed, defense spending increased dramatically as the 63

Reagan Changes the Course Reagan administration made good on its campaign promise to beef up the military in a showdown with the Soviet Union. According to Brookings Institution economist Barry Bosworth, the fiscal stimulus from the significant budget deficits, coupled with the “large capital borrowing that it entailed, collided with a monetary policy intent on restricting the supply of credit and economic activity to reduce inflation. The result was a sharp increase in interest rates that overwhelmed the investment incentives of the tax cut.”18 In other words, if the goal of the supply-side tax cuts was to create economic incentives that would lead to economic expansion and increased tax revenues, the experiment did not work. Government revenue declined precipitously. The supply-siders in the administration who had elevated the case for lower marginal tax rates into a full-blown economic theory, saw their position undermined as federal deficits skyrocketed. On the other hand, in all fairness to the supply-siders, the President’s increased military spending doomed their supply-side experiment from the start, as such growth in expenditures would have overwhelmed any favorable behavioral response attributable to the tax cuts.19 Soon after the enactment of the ERTA tax cuts, the traditional fiscally conservative center of the GOP (led in the Senate by majority leader Robert Dole of Kansas and Budget Committee Chairman Pete Domenici of New Mexico) reasserted control over the party in Congress. In the administration, OMB director David Stockman and White House Chief of Staff Jim Baker pushed for balanced budgets, even if it meant raising taxes. Even key business groups were now calling for a tax increase and deficit reduction.20 In August, Dole orchestrated the enactment of deficit reduction legislation to counter the effects of the 1981 tax cut. This bill was known as the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).21 The measure passed the House by 226 to 207 in a vote that crossed party affiliations. Voting in favor of the bill were 123 Democrats, while 89 Republicans voted against the deficit reduction legislation. Undoubtedly, the tax increases included in TEFRA were instrumental in dividing Republicans, who split along the cleavage between the antitax faction and the traditional fiscal conservatives. TEFRA included provisions proposed by the administration for strengthening compliance with the tax code. These compliance provisions, which raised just $12.8 billion in new revenue, included expanded information reporting on interest, dividends, and the gross receipts from the sale of securities. In addition, the infamous safe-harbor lease provision enacted only the prior year was repealed in the wake of considerable adverse publicity over big-time trafficking in tax preferences by major profitable corporations through safe-harbor leases.22 In total, about one-third of the business provisions enacted under ERTA were eliminated. The individual tax cuts enacted in 1981 were generally left untouched. In early 1983, the Reagan administration introduced proposals in its fiscal year 1984 budget that evidenced a discernable movement away from supply-side 64

Reagan Changes the Course principles. These included restrictions on tax-exempt leasing and tax-exempt bond issues by state and municipal governments, as well as a cap on tax-free employer medical benefits. Versions of these provisions found their way into a new tax bill that Congress took up the following year. The legislation, designated the Deficit Reduction Act of 1984 (DEFRA),23 included a number of revenueraising provisions, including new rules imputing interest on below-market loans and preventing premature accruals of tax deductions. On the floor of the Senate, Dole defended this effort to raise revenue by fine-tuning the tax code, putting the blame for the tax increases on Reagan and his deficit budgets: “The roots of this evening’s debate actually go back to February [1982], when the President [Reagan] released a budget calling for deficits in excess of $700 billion over the next 3 years. Those deficits were unacceptable by any criteria.”24 Dole and the fiscal conservatives had little faith in supply-side economics, preferring balanced budgets and restraint in spending. The fiscal conservatives ultimately prevailed in 1982. Indeed, Dole’s rise to power in the Senate, and later his nomination as the party’s presidential candidate in 1996, was in direct contrast to the decline in fortune of Kemp, the informal leader of the proinvestment antitax wing in the House. Kemp eventually resigned his congressional seat and made an unsuccessful bid for the 1988 Republican presidential nomination.25 Another leader of the GOP antitax faction in the House, Congressman Newt Gingrich of Georgia, enjoyed greater success, which ultimately culminated in his ascent to the position of Speaker. In another move to raise revenue, fiscal conservatives in Congress (Democrats as well as Republicans) proposed changes to the Social Security program— predicted to experience severe financial difficulties only some thirty years down the line. These changes were implemented in the Social Security Amendments of 1983. This legislation avoided reducing benefits to participants (always a tough political sell for politicians planning on running for reelection) by increasing the Social Security payroll tax rate as well as the tax base. The legislation also imposed income tax on one-half of Social Security benefits in excess of specified income thresholds. This was a bold move for policymakers in that such benefits had always been wholly exempt from income tax. Most significant, the bill raised the retirement age for Social Security recipients (from 65 to 67), such change to be phased-in gradually over twenty-two years commencing in the year 2003. Changing the retirement age is in effect a reduction of benefits; however, the extremely long-term phase-in for the change lessened the political fallout for policymakers. Overall, these changes to the Social Security program amounted to the largest tax increase of the decade. To no one’s surprise, Reagan stood for reelection in 1984. Despite his advanced age (seventy-three), Reagan proved more than fit to face the challenge from former Vice President Walter Mondale. During the campaign, candidate Mondale pronounced tax increases as inevitable in the face of mounting deficits. He was probably right about that, but the confession was a great tactical mistake 65

Reagan Changes the Course for a politician such as Mondale. The President and Republicans jumped all over him for his admission. In the end, the electorate simply did not want to hear about tax increases. The voters responded overwhelmingly to Reagan’s taxreduction message, casting over 54 million votes for the President. In the electoral college, Reagan won by a landslide, taking 525 electoral votes to 13 for Mondale (who carried only his home state of Minnesota and the District of Columbia). The people had spoken, and Reagan had four more years to increase military spending and cut taxes even further. During the second Reagan administration, tax policy made an unpredicted shift in direction as “tax reform” supplanted supply-side economics as the philosophy behind policymaking. Reagan initiated the campaign when, in his 1984 State of the Union address, he called on Treasury Secretary Donald Regan to study the feasibility of tax reform and simplification.26 In doing so, Reagan set in motion a two-year campaign for reform of the tax code. To his credit, the President recognized the problem that the increasing budget deficits presented. However, he refused to even consider the option of raising taxes again to reduce those deficits. “Now we know that deficits are a cause for worry. But there’s a difference of opinion as to whether taxes should be increased, spending cut, or some of both. . . . Simple fairness dictates that government not raise taxes on families struggling to pay their bills.”27 On the other hand, tax reform was possible if it did not impose a tax increase. Accordingly, the prerequisite for tax reform acceptable to the administration became “revenue neutrality”—meaning that all the changes to the tax code would be neutral in their overall effect on the tax imposed on the nation. Likewise, tax reform would be neutral with respect to the distribution of that tax burden among taxpayers. In the White House the main support for tax reform came from supplysiders who still wanted another significant reduction in the marginal tax rates imposed on the profits of small businesses and entrepreneurs. Eventually, a political compromise was reached between these supply-siders in the White House looking for lower marginal rates and liberal Democrats willing to accept lower tax rates in exchange for their goal: the elimination of tax loopholes and broadening of the tax base. The two groups came together in pursuit of a revenue-neutral bill that would lower marginal tax rates, such tax reduction to be financed through closing as many tax loopholes as possible. The result would be a broad-based income tax stripped of the numerous loopholes that had accumulated over decades of political intrusions into the tax policymaking process. The product of this odd political coalition of convenience for reform was the Tax Reform Act of 1986 (TRA).28 TRA has been widely hailed as the most significant tax-reform legislation in the long history of the federal income tax.29 In certain respects, it followed the traditional Republican antitax message. For instance, the legislation dropped the maximum tax rate for individuals to 28 percent. However, it also implemented a number of reforms that were traditionally favored by Democrats. TRA attacked 66

Reagan Changes the Course the growing business of trafficking in tax losses through the syndication of real estate tax shelters. The legislation also curtailed a number of other notorious provisions used by businesses to reduce their taxes, such as the completed contract method of tax accounting and the business deduction for the so-called threemartini lunch. Most surprisingly, TRA eliminated or severely restricted some of the most popular tax loopholes for individuals, such as the deduction for personal interest, the deduction for state and local sales taxes, contributions to individual retirement accounts, and deductions for miscellaneous itemized deductions. By virtue of the sheer volume of the revisions and amendments to the tax laws that it implemented, the 1986 act was the most massive restructuring in the eighty-year history of the federal income tax. This was not your typical Republican tax-reduction legislation. In contrast with the 1981 tax bill, which almost exclusively targeted tax reduction at high-income taxpayers in an effort to stimulate investment and the accumulation of capital, thereby reducing the progressivity of the tax code, the Tax Reform Act of 1986 slightly increased the progressivity of the income tax, notwithstanding initial efforts to achieve distributional neutrality for the legislation.30 It also must be said that the Tax Reform Act of 1986 may have stripped the tax code of numerous special interest provisions, but it certainly did not contribute to the simplification of the tax laws. Indeed, many of the reform provisions intended to limit the abuse of the tax system by the wealthy contributed substantially to the complexity of the tax laws. For the remainder of the Reagan years, supply-side economics never again regained the prominence or played the important role that it had in 1981. A core group of White House conservatives continued to pursue a supply-side tax policy agenda, but it was a futile effort. Proposals from the executive branch seldom even emerged from the congressional committees that were now controlled by largely unsympathetic Democrats. In the end, supply-siders saddled the GOP with a tainted legacy that it has yet to shed. During the Reagan years, taxes were reduced, but contrary to the predictions of the most ardent supply-siders, government revenue declined. In truth, the ballooning deficits were as much attributable to the failure to reduce budget expenditures during the mid-1980s (which resulted from the increased military spending by the Reagan administration) as to the tax cuts approved in 1981. The administration secured its requests for additional spending for the military. However, it proved impossible for Reagan to reduce the size of the rest of the federal bureaucracy. Some programs were cut, but others were created. The result was that the size of the federal government was greater in 1988, after eight years of Reagan’s tenure in office, than it had been in 1980 when he took office. So despite Reagan’s best efforts, the federal government was not cut down to size, government spending increased, income taxes were cut, and federal deficits skyrocketed. In the years subsequent to TRA, tax rates increased as politicians were forced to deal with those massive deficits. Taxes were further raised under budget reconciliation acts in 1987 and 1989. Even still, federal 67

Reagan Changes the Course deficits continued to increase. Reagan’s Republican successor in the White House, Vice President George H. W. Bush, was left to deal with the economic fallout. Bush Inherits a Deficit While the 1980s were a period of economic prosperity compared to the stagflation and low growth rates experienced during the 1970s, the decade ended with the economy sliding toward recession. In the decades following World War II, the federal government almost always operated in deficit. However, the financial shortfalls became more dramatic and significant in the 1980s in the wake of the massive tax cuts implemented in 1981 by the Reagan administration. The severity of the deficits temporarily eased as the deficit as a percentage of GNP fell from a peak of 6.3 percent in 1983 to 3.4 percent in 1988. However, the deficit rose again to 4.1 percent of GDP for fiscal year 1990, and early estimates were that it would approach 5 percent for fiscal year 1991.31 The accumulated national debt rose to over $3 trillion and the economy was faltering. Coming to office in January 1989 following his convincing victory over former Massachusetts governor Michael Dukakis, George Bush inherited the economic fallout from the Reagan fiscal policies that he had denounced as “voodoo economics” in the 1980 GOP primaries. Bush also inherited Reagan’s fiscal year 1990 budget, which was estimated to be $100 billion in deficit. In the end, the deficit actually turned out to be more than $218 billion in the red. The Bush administration stuck with the major outlines of the Reagan budget, resulting in an intense political battle with the Democratic leadership of Congress over the terms of the fiscal year 1990 budget. The parties did not reach agreement until the end of November (almost two months into the new fiscal year), following a sequestration imposed under the so-called Gramm-Rudman-Hollings budget act.32 As a result of the contentious partisan fight over the 1990 budget, the battle lines were drawn for an even nastier squabble over the budget for fiscal year 1991.33 Introduced by President Bush in January 1990, the fiscal year 1991 budget was only a very modest $63 billion in deficit. However, the midyear report of the Office of Management and Budget (OMB) provided a much more realistic and depressing message. Revised figures pegged the deficit at more than $168 billion—$231 billion if the federal government’s share of the savings and loan bailout was included, and nearly $300 billion if the temporary surplus generated by the Social Security Trust Fund was excluded from the computations. This was sobering news. A consensus emerged that something had to be done about the spiraling deficits. The Bush administration urged spending reductions, while Democrats generally favored increasing taxes. In an attempt to resolve their differences, the Republican administration entered into negotiations with the Democratic leadership of Congress. 68

Reagan Changes the Course During the summer of 1990, the administration’s negotiating team (led by OMB Director Richard Darman) and the congressional leadership came together at Andrews Air Force Base in Maryland for a budget summit. Negotiators adopted a target of $40.1 billion in deficit reduction for fiscal year 1991 and $500 billion over five years. The crucial questions was, Would deficit reduction come from tax increases or spending reductions? Democrats pushed for tax increases. The “no-new-taxes” president waffled and tentatively agreed to limited tax increases.34 The administration’s uncertain position allowed the congressional tax committees (chaired by Democrats) to control the negotiations, much to the President’s detriment.35 Ultimately, Congress and the President failed to reach agreement by the October 1, 1990 deadline, and the federal government was shut down over the Columbus Day weekend.36 Soon after the government shutdown (which put pressure on all parties), negotiations resumed, compromise was reached, and major tax legislation was enacted. The Omnibus Budget Reconciliation Act of 1990 raised some minor revenue through new user fees, a ten-cent increase in the gasoline tax, and increased excise taxes on liquor and cigarettes. Modest cuts in expenditures were included in the total package, and ultimately, most deficit reduction achieved was attributable to income tax rate increases. In the scramble for revenue, budget negotiators slipped into the tax code several particularly perverse provisions targeted at high-income taxpayers: a phaseout of personal exemptions and the benefit of the 15 percent tax bracket, as well as new limitations on certain miscellaneous itemized deductions. This was nothing more than a disguised tax increase for the wealthy.37 Over the years, there has been much criticism of these provisions among tax professionals and academics.38 Despite this, they remain in the tax code today (although the 2001 tax act provides for a gradual phaseout of the phaseouts) because under current budget rules, repealing them would require policymakers to come up with new offsetting revenue—not an easy or attractive political option at any time. With the 1990 budget deal, the decade began with tax policy adrift, headed down the road to nowhere. Neither Democrats nor Republicans were anxious to claim credit for the final bill, which resulted in only modest deficit reduction. The episode left the Bush administration shaken. Bush himself was eventually forced at the 1992 Republican National Convention in Houston to recant his political heresy of agreeing to raise taxes, but by then it was too late. His popularity, once at a historic 80 percent approval rating during the Gulf War with Iraq, plummeted. Following the 1990 debacle, the commitment of Republicans in Congress against tax increases hardened. After 1990, the Bush administration’s tax policy was adrift. The strategic political decision to repudiate the underlying premise of the 1990 budget agreement (accepting higher taxes in exchange for modest budget cuts) undercut the administration’s own position. When initiatives commenced in Congress for a new tax bill in the spring of 1992, the President was left on the sidelines. The 69

Reagan Changes the Course result was a Democratic tax bill that passed the House in July 1992. Imposing little in the way of budget cuts, the House bill dished out some $2.5 billion in new federal funding for social programs in the wake of the recent urban disturbances in Los Angeles. The Senate passed its own modified version of this urban aid tax package in September. The Democratic leadership of the tax committees, Dan Rostenkowski of Ways and Means and Lloyd Bentsen of the Finance Committee, sought to render the bill more acceptable to the Republican administration. The administration did not bite. In October, a compromise bill emerged from Congress, notwithstanding the President’s open threat of a veto. The veto came on November 4, 1992—one day after Bush was defeated in his bid for reelection. Lacking support to override the President’s veto, the bill was laid to rest. With Bush’s role in the 1990 budget summit, his veto of the 1992 tax bill, and his stunning electoral defeat, the legacy of his administration in the area of tax policy is that of deadlock. Tax policy continued along much the same path for the rest of the decade.

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4

The Tax Deadlock Decade The federal income tax code is un-American in spirit and wrong in principle. —Senator Peter V. Domenici of New Mexico (1994) [The tax code] is a monstrosity and there’s only one thing to do with it. Scrap it, kill it, drive a stake through its heart, bury it and hope it never rises again to terrorize the American people. —Presidential Candidate Steve Forbes (1995)

Tax legislation dominated the American political agenda in the 1980s. No less than six major revenue bills were enacted during the decade. In an amazing display of sustained legislative power and political compromise between supplyside Republicans and liberal Democrats, Congress virtually rewrote the tax code in 1986. On account of the great volume of tax legislation during the decade, economist Eugene Steuerle dubbed the 1980s the “Tax Decade.”1 Unfortunately, the 1990s proved to be no less exhausting for congressional tax policymakers—to say nothing of taxpayers. In many respects, tax policy was an even sorrier affair in the 1990s. At least in the 1980s, tax policymakers (Democrats and Republicans alike) could claim the historic Tax Reform Act of 1986 as their great success, even if the rest of the decade was marred by erratic and unstable policy. In the 1990s, tax policy was just erratic and unstable, without any comparable achievement to brag about. Republicans and Democrats in Congress engaged in a highly contentious and partisan politics that was often targeted at the tax code. In general, the legislative and executive branches were controlled by different parties, and consequentially, continually at odds over tax policy throughout the decade. However, while taxation was permanently on the policy agenda in the 1990s, little was actually accomplished or resolved. Indeed, the 1990s shall be less than fondly remembered as the Tax Deadlock Decade. The 1990s began with the Democratic congressional leadership locking horns over the budget with a Republican president in the White House. By the end of the decade, the tables were turned, with Republicans in control of Con71

The Tax Deadlock Decade gress and a Democrat in the White House. Most everything else remained the same. The Clinton White House and the Republican Congress were constantly deadlocked over the budget. The budget cycle has pretty much become an allyear process that commands inordinate time of Congress and has subsumed a good deal of the politics that used to take place within the realm of the appropriations committees. As the late Aaron Wildavsky wryly observed a decade ago: “Nowadays the State of the Union and the state of the budget have become essentially equivalent.”2 What Wildavsky failed to mention is that this neither bodes well for the budget nor the Republic. Because the budget process has emerged as the focal point of our national politics, tax policy is even more important today than ever before. The budget is now the instrument through which the majority party governs, and the tax code is one of the few tools available to federal policymakers for exercising control over the budget process, as well as implementing economic and social policy. This is as much by default as anything else, as reducing expenditures, or even holding them to current levels, is nearly impossible for elected politicians. The income tax is thus the primary instrument of fiscal policy for those politicians who would manage the national economy—which these days includes virtually all Democrats and a good number of Republicans as well. To further compound the problem, Democrats would use the tax laws to achieve their distinctly egalitarian vision of social justice (i.e., “soaking the rich” and rewarding labor and the education establishment), while Republicans have their own singular uses for the tax code—stimulating investment, encouraging the accumulation of capital, and generally reducing taxes for their wealthy constituents. Reflecting the deep-rooted ideological differences between the parties, tax policy has become a highly partisan affair. It also has become mired in the same politics of deadlock that has swamped the budgetary process. The result is not pretty. House Rules Committee Chairman David Dreier (R-Calif.) recently described the current budget process as “a disorganized patchwork of decadesold rules and laws” that simply do not work.3 The congressman should look at the tax code. Political conflict over tax policy, like that over the budget, expresses the same fundamental cleavages that define and divide the two major national political parties. If partisanship has weakened within the electorate at large, it has intensified within the halls of Congress where tax policy is made. And in the 1990s, that meant that tax policy was caught up in the impasse resulting from divided government. On the other hand, impasse and deadlock are often better than the kind of highly partisan policies inflicted on the tax code by Democrats and Republicans alike when a single party controls both the executive and legislative branches in Washington. What follows is a summary of the major tax legislation of the 1990s, Democratic as well as Republican initiatives. Some of these initiatives were enacted into law; others were proposed but stymied by the opposition party. In

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The Tax Deadlock Decade virtually all cases, federal tax policy was pursued within the context of a highly partisan and bitter clash between the two parties.

Clinton Soaks the Rich In the 1992 presidential election, Bill Clinton garnered only 43 percent of the popular vote, but it was enough to defeat the incumbent Republican President George Bush and Reform party candidate Ross Perot in a heated three-way contest. In the electoral college, Clinton’s victory looked even more impressive, taking 370 electoral votes to Bush’s 168. Perot, with almost 19 percent of the vote, collected no electoral votes. In that year’s congressional elections, the Democrats actually lost ten seats in the House and just held steady in the Senate. Obviously, Clinton’s coattails were not very broad. Nevertheless, when the dust cleared, Clinton moved into the White House and Democrats controlled both houses of Congress. This ended twelve years of divided government in Washington and dealt antitax Republicans a devastating setback. With Clinton’s election, tax policy returned to the patterns that prevailed in the 1960s and 1970s when Democrats controlled both Congress and the White House. During the 1992 presidential election campaign, candidate Clinton had promised that the budget deficit would be one of his administration’s highest priorities.4 Likewise, he promised that he would lower taxes on the middle class. Following the election, the president-elect reaffirmed both campaign pledges. However, economic reality soon caught up with campaign rhetoric as projections of a mounting deficit put an end to talk of tax cuts. As expected by Republicans, the new Democratic administration would deal with the deficit through tax increases, rather than spending cuts. Of course, the Republican administration departing from the White House had been unable to make much headway with cutting spending either. Just as higher tax rates dominated budget negotiations in 1990, so too would tax increases dominate proposals that emanated out of the White House in 1993. In his 1993 State of the Union address, Clinton presented the outline of his new budget plan to Congress. The budget plan included an assortment of recycled tax incentives, preferences, credits, and rate increases.5 Notably, the President committed to a proposal that was then popular among Democrats, a socalled millionaires surtax. Clinton transformed this into a 10 percent surtax on taxable income in excess of $250,000. Clinton’s “quarter-millionaires surtax” and his whole tax plan expressed a soak-the-rich tax policy that had not been so openly expressed in Washington since the 1930s. Directly targeting those who had benefited most from the 1981 Reagan tax cuts, virtually the entire burden of the 20 percent tax increase was imposed on the wealthiest taxpayers. Understandably, Republicans reacted bitterly. The level of partisanship and acrimony inten-

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The Tax Deadlock Decade sified. Indeed, the 1993 tax increase was the source of much of the partisan bitterness that prevailed for the rest of the decade. The revenue-raising provisions of the administration’s budget consisted mainly of increasing taxes on the wealthy. A new maximum tax bracket of 36 percent was proposed for individuals with income above $115,000, and the new 10 percent surtax would be applicable to taxable income above $250,000 (resulting in a top rate of 39.6 percent). The maximum tax rate on corporate income would be increased to 35 percent and the 55 percent maximum tax rate on gifts and estates (previously scheduled to decline to 50 percent) retained. Other provisions would repeal or limit deductions traditionally claimed by businesses. While ideologically driven and targeted at the wealthy, these proposals were also motivated by a more mundane and pragmatic consideration—the need for revenue. It is just that the revenue was to come from the constituency of the Republican party. To this end, the business deduction for meals and entertainment would be reduced to 50 percent from 80 percent. Employee deductions for moving expenses would be cut back and business deductions eliminated altogether for dues paid for membership in any social or athletic club and lobbying expenses. Corporate deductions for nonperformance-based executive compensation in excess of $1 million would be disallowed. Beginning in early 1993, the Ways and Means Committee took up consideration of the President’s plan. In a display of remarkable party coherence, Republicans uniformly opposed the entire package, leaving it to the Democrats to direct the mark-up as they pleased. Voting on the floor of the House for the final bill followed strict party lines, passing by the narrow margin of 218–216. The very next day, the Senate took up the bill. The Senate vote ended in a tie that was ultimately decided by Vice President Al Gore in his capacity as president of the Senate. The Revenue Reconciliation Act of 1993 was signed into law by President Clinton on August 10, 1993.6 The legislation included virtually all that Clinton had proposed, other than an ill-conceived broad-based tax on energy (the so-called BTU tax) that ran into fatal opposition from representatives from oiland-gas producing states. The politics surrounding the 1993 tax bill resembled that which had previously characterized the 1990 tax legislation. The budget crisis played a crucial role in orienting tax policy toward tax increases. Likewise, while the President’s initiatives served as the basis for tax legislation, congressional politics and interests dominated the policymaking process. Most significantly, the level of partisanship over tax policy markedly intensified. Congressional voting followed strict party lines. If Republicans had offered lukewarm support for bipartisan tax legislation in 1990, they would never again vote with Democrats on a tax bill for the rest of the decade. The soak-the-rich philosophy behind the 1993 Democratic tax legislation was highly divisive and provoked an equally partisan response by Republicans in the years that followed.

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The Tax Deadlock Decade The Resurgent GOP: 1994 The origins of the current partisan framework for federal tax policy can be traced to November 1994. That is when Republicans secured an overwhelming victory in the 1994 midterm congressional elections, exceeding even their most optimistic expectations. While the GOP briefly held a majority in the Senate from 1980 to 1986 during the Reagan years, the House had been under the control of Democrats for forty straight years—the longest period of one-party rule in the history of Congress. By way of illustration, when the GOP became the majority party in January 1995, only one member of Congress (Rep. Sidney Yates, an eighty-eight-year old Democrat from Illinois) had served in the last Republican-controlled House, which was way back in the 83rd Congress during the Truman years. With their strong showing in November 1994, Republicans gained concurrent control of both chambers of Congress for the first time since the disastrous 1954 midterm elections. Of course, this left the national government once again divided, with Democrats holding on to the White House and a particularly conservative group of Republicans controlling Congress. The so-called fourparty system that historian James MacGregor Burns has associated with the “deadlock of democracy” took a firm hold on Washington politics in January 1995.7 Tax policy did not escape its grasp. Most of the major domestic public policies enacted by Congress in the decades following World War II were crafted by the majority Democratic party, with only peripheral input and slight deference paid to the views of minority Republicans. As the perpetual minority party in Congress, senior Republicans had been relegated to secondary status in the hierarchy that rules Congress—the important committee system. In Congress, all the chairmen of the standing committees are filled from the ranks of the majority party. Except for the six years of Republican control of the Senate (when Bob Dole of Kansas served as majority leader, as well as chairman of the Finance Committee), the Democratic party controlled the congressional committee system, thereby directing the course of congressional policymaking during the entire period from 1955 through 1994. As a result, Democratic hegemony extended over federal tax policy. That ended with the 1994 elections. With newfound support in the West and South, the Republican party had approached the November 1994 elections with modest expectations of reaching parity with the Democrats. However, a small group of young conservatives in the House had been actively planning for a Republican takeover of the House for years. One particularly aggressive young congressman, Newt Gingrich of Georgia, joined with several other junior House Republicans to found the Conservative Opportunity Society in 1982 in an effort to consolidate conservative opinion in the party. Gingrich, who was first elected to Congress in 1978 after

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The Tax Deadlock Decade several unsuccessful campaigns, used the group to cultivate a more organized conservative bloc in the party. Then in 1988, he took over GOPAC, a Republican political action committee, and transformed it into a vehicle for training new Republican candidates expressly in an effort to take over the House. Gingrich raised and spent over $8 million through GOPAC from 1991 to 1994 in preparation for the day when Republicans might finally win a decisive victory in the House.8 The 1994 election provided that opportunity. It helped that there was no shortage of discontent among Democrats with Bill Clinton’s failure to advance his new policies—for instance, his policy for permitting gays to serve in the military, as well as the President’s and First Lady Hillary Rodham Clinton’s highly publicized initiative for massive changes to the national health-care industry. Recognizing that the Democrats were in a vulnerable position, Republicans worked even harder to cultivate their grass-roots conservative base. In particular, they cemented relations with the New Right—especially with Pat Robertson and Ralph Reed, leaders of the well-organized Christian Coalition, which at the time claimed 1.5 million members and offices in all 50 states. Gingrich first proposed his concept of a single campaign platform for all Republican House candidates at a GOP retreat early in 1994. He formulated the notion of a “vision statement” containing ten specific pledges to which the GOP congressional candidates would bind themselves, and if elected as a GOP majority, implement within the first hundred days of the 104th Congress. This platform of the Republican congressional candidates soon became known as the Contract with America. According to political scientist Nicol Rae, the Contract with America served three basic functions: to unify the Republican party; to nationalize the campaign around a set of issues favorable to the GOP; and to provide a legislative agenda in the event the GOP actually captured the House.9 In all respects, things worked out better than Gingrich could have imagined at the time. In the Senate, the GOP took a net gain of eight seats to give them a slim 52 to 48 advantage. Subsequent to the election, Democratic Senator Richard Shelby of Alabama switched parties, giving the Republicans a somewhat more secure 53 to 47 majority. However, in the House, Republicans picked up a whopping net gain of 52 seats, giving them a definitive 230 to 204 majority (with one independent). While there is broad agreement among political scientists that these results did not foretell some impending critical election or realignment of the national party system, the increased Republican strength was certainly caused by some significant demographic changes. The once solid Democratic South now enjoyed vigorous two-party competition in most states, and some regions had even become Republican strongholds.10 As a result, in January 1995, the Republicans saw the balance of power shift in their direction just enough to give them the House and the Senate. Suddenly it was the turn of the Republicans, long excluded from the inner sanctum of power, to take over the helm of the national legislative branch. With such little prior legislative experience, the Republican 76

The Tax Deadlock Decade leadership would have to learn how to direct the nation’s policymaking process.11 The first step was to appoint the chairmen of the standing committees of Congress. By virtue of the GOP’s majorities in both house, the Republicans assumed the right to appoint the chairmen of all the committees of Congress. Under new Republican party rules enacted with the opening of the 104th Congress, the power to make committee assignments among House Republicans would rest with the Committee on Committees, a group comprised of the minority leader, the whip, and various representatives of constituencies within the party. This was in stark contrast with the rules followed by Democrats during the 103rd Congress (in particular, Speaker Tom Foley of Washington), who strictly followed seniority in appointing committee chairs despite increasing pressure from reformists against that practice.12 In general, the Committee on Committees nominates candidates for the chairmanships, and these candidates are thereafter approved by the Republican Conference. Chairmen would be limited to three consecutive terms. Under the new rules, all the chairs of all the important committees in the House—Rules, Budget, Ways and Means, and Appropriations—would be filled by Republicans who were favored by the GOP leadership. Generally, that meant the senior Republican on the committee, but not always. In the early days of the 104th Congress, the Committee on Committees designated several individuals who lacked seniority to serve as committee chairs.13 Furthermore, in a number of important cases, House committee chairmanships fell to some of the most conservative, antitax Republicans in the party. For example, Bill Archer of Texas, a dedicated conservative with a long history of opposition to federal taxes, assumed the chairmanship of the important House Ways and Means Committee, which has primary jurisdiction over all tax and revenue legislative bills. Under the Constitution, revenue bills must originate in the House (which means Ways and Means) before going to the Senate.14 This places great power in the hands of the committee chair, and Archer relished the opportunity to use that power to shape the coming debate over tax policy. Archer dedicated himself to replacing the federal income tax as the principal source of revenue of the government in Washington: “I firmly believe that we’ve got to look at a new way of raising revenue than the income tax.”15 Likewise, most of the important positions of leadership in the House fell to conservatives who were partisans of the antitax cause. Gingrich, who successfully orchestrated the Contract with America campaign, assumed the position of Speaker as party leader Bob Michel had not run for reelection in 1994. The new majority leader, Richard Armey of Texas, immediately commenced a campaign to repeal the income tax and replace it with a “flat” consumption-based tax. Short of that goal, Armey emphasized significant income tax reduction. Other Republicans with equally strong hostility to taxation assumed other important positions of party leadership in Congress. One of Gingrich’s close associates, Tom 77

The Tax Deadlock Decade DeLay of Texas, took over as majority whip—the third highest position within the GOP House leadership. DeLay is a former Amway salesman who went into the pest-control business and became, in his own words, the “best weasel killer in Houston.”16 A hard-nosed conservative, DeLay is strongly opposed to federal environmental and safety regulations, perhaps based upon his past experiences in the weasel-killing business. He also advocates tax reduction and is a formidable proponent for the cause. The Republicans in the Senate were generally more moderate and pragmatic in their demeanor than their House colleagues, but were no less interested in tax reduction. Their new leadership positions reflected that concern. For example, Trent Lott of Mississippi contested Alan Simpson of Wyoming for the position as the new majority whip—the number two spot in the Republican party hierarchy. Despite opposition from majority leader Bob Dole, Lott was the preferred candidate among Senate Republicans (albeit by a slim 27–26 majority). Lott, who won a Senate seat in 1988, is not a rabid antitax Republican. Indeed, many recognize him as a moderate quite capable of compromise. However, he was perceived as more conservative than Simpson, and while previously serving in the House, had consistently supported Republican initiatives to cut taxes. Lott subsequently replaced Dole as Senate majority leader in June 1996 during the 105th Congress when Dole resigned his seat to run for president. By that time, he was considered to be more fully in tune with the radical Republicans in the House. Under a different set of rules providing greater deference to seniority, Republicans likewise assumed control of all the standing committees in the Senate. Important committee chairmanships, as well as seats on those committees, also were awarded to antitax Republicans. Later in the session, William Roth of Delaware, an active sponsor of tax cuts for decades (for instance, as cosponsor of the so-called Kemp-Roth tax reduction proposal of 1977), became head of the important Senate Finance Committee following long-time chairman Bob Packwood’s forced resignation from the Senate in September 1995. The Finance Committee has jurisdiction over tax and revenue matters that come before the Senate, and now the committee was under the leadership of a bona fide antitax Republican. After decades as outsiders, the antitax wing of the GOP suddenly dominated the leadership of the party, the congressional committees, and with that, the hallowed halls of Congress. While there was an overall centralization of power within the committees under the new Republican rules in the House (which gave greater power to committee chairs, as opposed to subcommittee chairs, than did the Democratic rules followed in the 103rd Congress), the committees chairs themselves were generally subordinate to the congressional leadership on the most important legislative matters brought before the 104th Congress. The more aggressive Republican leadership in the House took the initiative in most cases, leaving the Senate to respond to their proposals. In any event, Republicans who had watched 78

The Tax Deadlock Decade for decades as Democrats wrote most major legislation enacted during the past four decades were now in control of Congress, and they were ready and willing to use the opportunity to redirect public policy.

GOP Freshman Class of 1995 The seventy-three Republicans who were sworn in as new members of the U.S. House of Representatives in January 1995 were a breed apart from their more senior colleagues. Compared to prior generations of Republican legislators, they were generally younger and more conservative than their own party leadership—especially that of recent decades (e.g., Charles Halleck, Gerald Ford, and Robert Michel). Aggressive, conservative, and highly ideological, the Republicans in the freshman class of the 104th Congress were more likely to come from “middle America” in the West and Midwest than from the Northeast (home of the moderate and “liberal” elements of the party). Most saw themselves on a mission to reform the entire political system, viewing the “politics as usual” of Washington as corrupt and beyond repair. They would go to Washington, shrink the federal government, balance the federal budget, and then head back to the heartland of America from whence they had come. As a whole, the GOP freshman were less likely to be career politicians or public officials, thus confirming their self-proclaimed image as “outsiders”— although not nearly to the extent they sought to portray.17 Half of the freshmen had never held any public office before being elected to Congress. Many owned small businesses prior to running for Congress. These included an insurance agency, accounting firm, real estate, and construction.18 In one important respect, the freshmen were exactly like their senior colleagues in both parties—raising money to finance their elections. All but four of the seventy-three GOP freshmen took money from political action committees (PACs), and most took contributions from lobbyists.19 Despite their hostility to “politics-as-usual” in Washington, it was impossible for the GOP freshmen to escape the demands and pressures for money that impinge upon the independence of all members of Congress. Lacking the patience of senior Republicans tempered by decades of minority status, the GOP freshmen were impatient with the pace of the legislative process. Intent upon changing the direction of national policymaking, the freshmen were unwilling to wait as the wheels of Congress slowly turned. This meant shaking up the House and changing the way its leadership did business. Notably, all but five of the members of the GOP freshman class had signed the Contract with America in a publicized ceremony on the steps of the Capitol on September 27, 1995. Having run on such a highly partisan campaign platform, the GOP House freshman class was dedicated to making a conservative revolution and impatient for the revolution to begin. On the whole, the Republican freshmen 79

The Tax Deadlock Decade belonged to the Right Wing of the GOP and were uniformly hostile to all forms of federal taxation—especially, the income tax and gift and estate tax. They did not like Bill Clinton much either. For example, only the admonitions of their esteemed Republican Speaker, Newt Gingrich, prevented the GOP freshmen from razzing the President when he came before a joint session of Congress to give his January 1995 State of the Union address. Under Gingrich’s tutelage, the first hundred days of the 104th Congress were dedicated to enacting into law the entire Contract with America. This would mean significant reform of the tax code as the Democrats had written it over the past forty years. Furthermore, with the support of the freshmen class, the new leadership of the Republican party was in a position for the first time since 1954 to challenge the post–New Deal order. This included reevaluating and restructuring the whole arsenal of taxes that finances the activities of the federal government.

The New Republican Agenda Of the twenty-one items included in the Contract with America, a significant number provided not for conservative social policies or programs, but rather for amendments to the Internal Revenue Code. Apparently, the new conservative revolution would be implemented through the tax laws. The most important of these tax proposals in the Contract with America provided for reducing the tax on capital gains, increasing the unified life-time credit for the estate and gift tax, expanding the contribution limits for individual retirement accounts (IRAs), creating a new tax credit for parents, and eliminating the so-called marriage penalty in the income tax. Most of these proposals were included for the benefit of key constituencies within the Republican party. For instance, the child tax credit and relief from the marriage penalty were there primarily to appease the religious social conservatives who had actively campaigned for Republican candidates in key House races. It was now payoff time for Ralph Reed and the Christian Coalition (which spent over $1 million campaigning for the Contract in 1994), and payment would take the form of tax credits. Given the electoral triumph of the Republican party in 1994, the odds of these Contract tax provisions making their way into the tax code seemed promising. The new chairman of the House Ways and Means Committee, Bill Archer, and the new majority leader, Dick Armey, were just the right ones to lead the campaign in the House. Under the tutelage of the two Texans and the Speaker from Georgia, all the tax-reduction proposals were incorporated into a new Contract with America tax bill (rather pompously labeled the “American Dream Restoration Act,” H.R. 1215) that sailed through the House in March and April of 1995.20 Predictably, each of the provisions in the Contract tax bill produced a strong partisan howl from Democrats—who, during their long tenure at the 80

The Tax Deadlock Decade helm of the tax-writing committees, had crafted the very tax regime now under assault. The largest single item in the House tax bill was a new nonrefundable $500-per-child tax credit. This “pro-family” credit was a nonnegotiable item pursued by the aggressive, highly partisan, and unified block of freshman House Republicans. On the other hand, the Senate was lukewarm toward the credit, with moderate Republicans opposed to enacting such a significant revenue loser in the midst of a major effort to balance the budget. The $500 child credit was scored by the Joint Tax Committee as costing some $147 billion over seven years.21 Introducing a phaseout for higher-income taxpayers would significantly reduce the cost of the tax credit, but that was opposed by conservatives who favored a credit available to all taxpayers. The second most significant item in the House tax bill was a tax preference for long-term capital gains. For individual taxpayers, there would be an exclusion for 50 percent of long-term capitals gains; for corporate taxpayers the maximum capital gains tax would be capped at 25 percent. This preference was scored by the Joint Committee on Taxation as costing $35 billion over seven years. The Senate generally followed the House, except that the top corporate rate was fixed at 28 percent and indexing of capital assets was left out altogether. This and other changes to the House bill reduced the seven-year revenue loss by over $12 billion. Senator Bill Roth of Delaware used the power of his new position as chairman of the Finance Committee to advance his favorite cause— expanding IRA coverage. Senate modifications to the House bill included a more generous expansion of the eligibility requirements for existing individual retirement accounts (IRAs), including new allowances for tax-free withdrawals for qualified expenses. Both the House and Senate bills provided for new “medical spending accounts” modeled on IRA accounts. The whole Contract with America tax bill met with only a lukewarm response in the Senate. Action was delayed for months as the more moderate Republicans in the Senate sought to craft their own version of the tax bill. The Senate mark-up eventually passed on October 28 by a 52– 47 vote with all Democrats voting against the bill and all but one Republican (William Cohen of Maine) voting for the tax reduction bill. After conference, the House accepted the more moderate version and in December 1995 the bill was sent up to the White House, where it ran smack into Democrat Bill Clinton. President Clinton promptly vetoed the Republican tax bill. Notwithstanding the President’s veto, House Republicans persisted in their effort to enact the new social conservatives’ agenda through the tax laws. As a result, a full-scale assault on the federal tax laws by the antitax wing of the GOP continued for the rest of the decade. Indeed, the Republican antitax policies reflected a broader challenge to the basic financial structure of the American state. In the 1990s, conservatives in the Republican party were in the forefront of a movement to challenge the established methods of financing the liberal pro81

The Tax Deadlock Decade grams of the post–New Deal American state. Congressional Republicans, especially those in the House, proposed significant structural changes to the financing of the American state. The Contract with America platform of congressional Republicans in 1994 offered up the blueprint for this proposed refinancing of the American state. The new conservative agenda was expressed in a strong antitax rhetoric and given content in a platform of tax cuts designed for the benefit of the main constituents of the Republican party. This antitax agenda influenced the tenor of American politics. For example, 43 percent of House members in 1995 signed the “Taxpayer Protection Pledge” of the conservative interest group Americans for Tax Reform, pledging not to vote for tax increases. The most vilified target of the new GOP fiscal revolution was the federal income tax. Bill Archer, chairman of the House Ways and Means Committee, actively campaigned for the repeal of the federal income tax even during markup of the Contract with America tax bill. In speech after speech across the country, Archer proclaimed his contempt for the income tax: “I personally would like to tear the income tax out by its roots and throw it overboard.”22 House Majority Leader Armey led his own crusade to replace the income tax with a socalled flat tax. In essence, the Armey flat tax proposal is a two-tiered “cash-flow” consumption tax imposed on businesses and individuals at a flat 17 percent rate.23 The Treasury Department quickly put something of a damper on Armey’s plan; it estimated that a 17 percent flat tax would cost $244 billion in lost revenue a year. Treasury calculated that a 25.8 percent flat tax would be needed to achieve “revenue neutrality.” Later, the Joint Committee on Taxation issued its own highly critical analysis of the flat tax proposals.24 Two-time GOP presidential candidate Steve Forbes adopted his own version of the flat tax as his central campaign issue. Forbes espoused the strongest antitax rhetoric on the campaign trail, urging voters to “[scrap] the income tax. Don’t fiddle with it. Junk it. Throw it out. Bury it. Replace it with a pro-growth, pro-family tax cut that lowers tax rates to 17 percent across the board.”25 Beyond such rhetoric, Forbes offered few specifics in his antitax campaign. Throughout the 1990s, it seemed as if every Republican candidate to run for office had his own special plan for eliminating the federal income tax. Even moderate-to-liberal Republican presidential hopeful Senator Arlen Specter of Pennsylvania introduced his own flat tax proposal substantially similar to that of Armey—the key differences being a flat 20 percent rate, lower personal exemptions, and limited deductions for charitable contributions and home mortgage interest. Senator Richard G. Lugar of Indiana, would-be Republican presidential candidate in 1996, became an ardent supporter of a national sales tax to replace the income tax. Lugar proposed a flat 17 percent sales tax on all goods and services (excepting food and medicine, to mitigate the overall “regressive” impact of a sales tax). Like Armey’s flat tax proposal, the Lugar tax plan would come up far short in raising revenue. Perhaps that was intentional. The post–New Deal administrative state would be reined in by cutting off its main source of 82

The Tax Deadlock Decade nourishment—namely, the enormous revenue brought into federal coffers by the income tax. As House Budget Committee Chairman John Kasich would later put it: “The end game here is to strip the government of the financial means for butting into the lives of Americans, and thus, returning power and responsibility to families and localities.”26 So the GOP fiscal revolution took aim at the income tax as it had evolved during the prior eighty years—mostly under the tutelage of Democrats in control of the tax committees that write the tax laws. Obviously, attacking the income tax was nothing new in the Republican party. The progressive rate structure of the income tax had been under attack for over eighty years by congressional Republicans. The intense and highly ideological battles from 1947 to 1948 between Democratic President Harry Truman and the Republican 80th Congress were most often over tax cuts. Likewise, Ronald Reagan put tax reduction at the center of his domestic policy program. Whatever tax relief the wealthy had enjoyed during the Reagan era was more than reversed by Bill Clinton in 1993 as the heavy burden of the income tax was placed directly on the wealthiest taxpayers. There were powerful forces in the Republican party intent upon reducing this tax burden on the wealthy. While directly and openly campaigning for tax relief for the wealthy is a tough sell for Republicans in a general election, the GOP managed in the 1990s to package precisely that objective under the guise of various “tax reform” proposals. Certainly, the flat tax crusade was never marketed on the basis of a tax reduction for the wealthy—even though that was precisely the economic impact of all the many flat tax proposals floating around. Much the same could be said for other GOP tax reform proposals, such as those to end the marriage penalty and legislation to repeal the federal gift and estate tax. Each of these Republican tax reform initiatives (discussed further in subsequent chapters) would provide significant tax relief for the wealthiest taxpayers. Each was marketed by the GOP in the political arena as a remedy for some injustice inflicted upon the American people by the Internal Revenue Code. It was left to the Democratic opposition to challenge these proposals on the basis of favoring the wealthy—which Democrats instinctively do without much reflection. The Republican assault on the income tax, as well as the gift and estate tax, would challenge the basic structure of the system for financing the federal government. But ultimately, it was President Clinton who had the last word. The President was initially thrown off kilter by the Republican onslaught, meekly reassuring the American public that he remained “relevant” despite the GOP juggernaut.27 However, it was not long before Bill Clinton recovered his balance. He vetoed virtually every Republican tax reduction measure to come out of Congress between January 1995 and December 2000. The few items off the GOP Republican antitax agenda that were actually enacted into law under the President’s signature hardly made for a conservative fiscal revolution. 83

The Tax Deadlock Decade Notwithstanding the efforts of Speaker Gingrich and the House Republicans, the would-be refinancing of the American state in the first hundred days of the 104th Congress proved a failure. However, the very same tax and fiscal issues would dominate the domestic policy agenda for the rest of the decade. But, with a Democratic president flatly opposed to the GOP antitax plan and all too willing to use his veto to block its implementation, remarkably little of the Republican agenda was enacted into law. Most of the platform was recirculated year after year throughout the decade. The new conservative revolution heralded by the triumph of House Republicans in the 1994 elections produced as little in the way of concrete changes to the institutions of American government and public finance as had the Reagan revolution of the 1980s.

Balanced Budget and Tax Reduction in 1995 The 1995 Contract with America tax bill was only one element in the Republicans’ massive legislative effort to reform Medicaid, Medicare, and balance the federal budget by the year 2002. The crafting of this omnibus revenue bill perfectly exemplifies how tax policy has become engulfed in the broader debate over the budget. Most major tax legislation is now introduced as part of the budget reconciliation process. Indeed, the Republican leadership used the fiscal year 1996 budget as the main vehicle for enacting their political agenda—tax cuts and all. An omnibus revenue and budget bill was jointly crafted by the chairmen of the Budget Committees, John Kasich in the House and Pete Domenici in the Senate, both strong proponents of a balanced budget. A seven-year plan for balancing the budget was adopted by the Republican leadership. This plan was incorporated into the omnibus budget bill by the budget chairs. The bill reported by the Budget Committees passed the House by a vote of 237 to 189 on November 17, and the Senate followed suit later that same day. On November 30, the Seven-Year Balanced Budget Reconciliation Act of 1995 was sent up to President Clinton for his signature. That was not forthcoming. Clinton followed through with his oft-repeated promise and vetoed the legislation on December 6, 1995. The Republican plan to refinance American domestic policy was stopped dead in its tracks. Despite his veto, Clinton expressed willingness to compromise on at least some of the proposals included in the Republican bill. This demonstrated just how far House Republicans had come in shifting the framework for the political debate, even if they could not actually get what they wanted most: a big tax cut. Specifically, the President accepted the idea of balancing the budget over seven years (down from his prior commitment to a ten-year timetable). He also was willing to accept some form of a new child credit, a new deduction for educational tuition, a phaseout of existing IRA saving accounts for those with high incomes, and new IRA-styled savings accounts with penalty-free “back-end” 84

The Tax Deadlock Decade withdrawals for qualified expenses. Likewise, Clinton was willing to commit to deeper cuts in discretionary spending. The White House would reduce Medicare spending by $124 billion over seven years—that compared to the $270 billion that Republicans proposed. Overall, Clinton would accept $105 billion in gross tax cuts over seven years, offset by $35 billion in additional revenues over the same period. Nevertheless, the White House held firm on other issues, rejecting any increased preference for capital gains or estate tax exemptions. Similarly, Clinton refused any modifications to the much despised corporate alternative minimum tax. The administration plan embraced several of the GOP’s revenue raisers and also proposed several others aimed at corporate taxpayers. These would raise some $20 billion over seven years.28 One of the main bones of contention left between the White House and congressional Republicans was the economic assumptions underlying each other’s respective plans for balancing the budget. Congressional Republicans relied upon the relatively conservative economic forecast of the Congressional Budget Office (CBO), which predicted a slightly lower rate of annual growth for the economy than did the Office of Management and Budget (OMB), which itself was more conservative than most Wall Street economists. The White House used OMB projections forecasting a 2.5 percent annual growth rate, while congressional Republicans relied upon the 2.3 percent rate from CBO. This seemingly minor 0.2 percent difference between the CBO and OMB economic forecasts required $400 billion in extra cuts under the congressional plan in order to bring the budget into balance by the year 2002. The impasse was bridged when CBO revised its economic assumptions in a new December report.29 CBO’s more rosy economic forecast meant that there was an extra $135 billion in revenue to play with, thereby closing the gap between congressional Republicans and the Democratic White House to only $300 billion over seven years. On paper, this extra revenue would help achieve a balanced budget, even while accepting the reduced cuts to Medicaid and Medicare spending demanded by Democrats. Attempts to reach agreement between Congress and the White House on an overall balanced budget plan continued throughout the second week of December. The Republican leadership gambled that President Clinton would not dare risk shutting the government down, knowing how the October 1990 shutdown had cost his Republican predecessor, George Bush, so dearly at the polls. They believed that eventually he would capitulate, rather than risk another shutdown. The federal government had already been partially shut down for six days starting November 14, with some 800,000 “nonessential” federal workers kept off the job. A temporary spending measure had been adopted by Democrats and Republicans to bring federal employees back on the job and avert a default on federal debt obligations, but this authorization lasted only until December 15.30 In the end, even the threat of another shutdown could not bring the parties to compromise. Clinton did not cave. Negotiations ended abruptly with the 85

The Tax Deadlock Decade federal government shutting down following the expiration of the temporary spending measure at midnight on December 15, 1995. The December shutdown was more limited than that experienced in November, as nine of the thirteen required appropriations bills were already in place. Still a number of “minor” Cabinet departments (including Interior, Labor, and Health and Human Services, as well as independent agencies such as the EPA and NASA) were forced to close operations. Negotiations peaked and ebbed the week before Christmas. But in the wake of a threatened revolt by House Republican freshman against their more “moderate” leadership, positions hardened. Republicans declared that budget talks could not continue until the President negotiated in “good faith” (meaning on their terms). Negotiations reached deadlock. The December recess came, the government remained shut down, and the first session of the 104th Congress ended with neither a budget in place for fiscal year 1996 nor the enactment of any tax reduction legislation.31 But rather than suffering at the polls, Clinton had the better of the congressional Republicans, who were the ones blamed by the public for the budget stalemate. Indeed, the Republican revolution was knocked off stride by the confrontation with Clinton. Thereafter, the President’s popularity began to rise steadily, while that of the House Republicans sank. This was especially true with respect to the fortune of Speaker Gingrich. In one particularly strange story that made national headlines, Gingrich complained that the President had snubbed him and Bob Dole on a transatlantic ride on Air Force One to the funeral of the slain Israeli Prime Minister Yitzhak Rabin. The Speaker was portrayed as a petty whiner in press accounts of the incident. Clinton came off looking like roses, and the Republican fiscal revolution stalled. Of the many items on the Contract with America agenda, only two had been enacted into law by the close of the year—a curb on unfunded federal mandates to the state governments and the application of federal labor laws to Congress. Of such things a conservative fiscal revolution is not made.

1996: A Quiet Year for Taxes While the election year of 1996 was generally considered an “off year” for tax legislation, several major domestic policy initiatives were enacted into law that included substantial amendments to the tax code. House GOP leaders opened the year by attempting to attach a limited tax package to a bill for raising the national debt limit. Purportedly, the GOP package was to include several items off the failed 1995 Contract tax bill.32 Later in February, the Republican leadership unveiled its plan, which included a capital gains tax cut, a child tax credit, pension protection, and a constitutional amendment to limit tax increases. A separate bill introduced in the House by James M. Talent (R-Mo.) and J. C. Watts Jr. (R-Okla.) proposed creating new “renewal communities” in low-income 86

The Tax Deadlock Decade areas. While Speaker Gingrich endorsed this plan for a new version of empowerment zones, the bill never made it through the House.33 Legislation to increase the debt ceiling to $5.5 trillion passed the House on March 28 by a vote of 328 to 91. The bill did not include the GOP mini-Contract tax package that the Republican leadership had been talking up for weeks in the press, but it did include a line item veto measure granting the President authority to veto certain tax provisions. The line-item veto was subsequently removed from the legislation, passed by Congress as a separate bill (S. 4), and sent to the President for his signature.34 On April 9, President Clinton signed into law the Line Item Veto Act of 1996, which granted the President veto power (subject to Congressional approval) over any revenue-losing measure that provides a federal tax deduction, credit, exclusion, or preference to 100 or fewer taxpayers—a socalled targeted tax benefit.35 The next year, Clinton used the line item veto power to strike down two provisions from the Taxpayer Relief Act of 1997. However, the legislation was immediately challenged in the federal courts and subsequently ruled unconstitutional by the Supreme Court.36 In April and May, congressional Republicans took up consideration of legislation to reform health care insurance. The legislation stalled in the Senate owing to opposition to a provision in the House bill (H.R. 3103) creating medical spending accounts. In June, the Senate Finance Committee also began markup of another bill (H.R. 3448) offering tax relief to small businesses. At the same time, the health insurance reform bill emerged from Conference Committee after negotiators reached agreement on medical savings accounts. In late August, the President signed into law the Health Insurance Portability and Accounting Act of 1996. At the same time, Clinton signed the Small Business Job Protection Act of 1996, a ten-year $20.5-billion package of provisions granting tax relief to small businesses. That same month, Republicans also sent up to the President sweeping welfare reform legislation (H.R. 3734), which he signed in the same blitz of domestic policy legislation. The welfare reform bill, the Personal Responsibility and Work Opportunity Reconciliation Act of 1996, also included several tax provisions, most prominently an additional $3.2 billion for reforms to the earned income tax credit. Of the three major bills enacted in August 1996, the Small Business Job Protection Act included the most significant amendments to the income tax. The legislation contained numerous provisions affecting businesses, simplifying pension rules, expanding contributions to IRAs, and extending expired tax provisions. Among the many tax provisions included in the Small Business Job Protection Act was a measure that increased the deduction for health insurance for selfemployed persons from 50 percent to 80 percent over ten years. The legislation also increased over seven years the deduction allowed under section 179 of the tax code for capital expenditures from $17,500 to $25,000, and enacted a new tax credit for up to $5,000 of expenses incurred in adopting a child. Under a reform proposal introduced by the administration, the deduction for company-owned 87

The Tax Deadlock Decade life insurance (COLI) was limited. The law established that the exclusion from gross income for amounts received as damages for personal injury or sickness applies only to damages for a physical injury or sickness. The legislation also included a provision that was previously introduced as a stand-alone bill. That proposal created an entirely new “pass through” entity, the Financial Asset Securitization Investment Trust (FASIT).37 The new entity was a gift to the financial community, which decided that it needed a new tax-favored vehicle for the securitization of general debt obligations, such as credit card receivables, home equity loans, and automobile loans. The individual debt obligations are gathered together in a FASIT and pieces are sold off to investors. Wall Street asketh and the Republican Congress giveth! The Small Business Job Protection Act also included a major overhaul of Subchapter S of the Internal Revenue Code, dealing with so-called S corporations (i.e., those taxed under Subchapter S of the Internal Revenue Code). For many years, proposals were introduced to modify and modernize the law governing S corporations. These efforts finally bore fruit in 1996. Under the new legislation, which was supported by the tax bar and accounting profession, to say nothing of the business community, the limit on the number of shareholders for an S corporation was raised from 35 to 75. In addition, under revised Subchapter S, an S corporation is permitted to be a member of an “affiliated group,” and hence, can own 80 percent or more of a C corporation (i.e., those corporations taxed under Subchapter C of the IRC), as well as have a wholly owned subsidiary that itself is an S corporation. Another significant change allowed certain taxexempt organizations as shareholders of S corporations. All these changes were intended to make S corporations more flexible entities for raising capital and investment in small- and moderate sized businesses that operate in corporate form. Republicans got a few of the more modest tax provisions on their wish list, but none of the really big ticket items. In October 1996, Ways and Means Committee Chairman Archer announced that a capital gains tax cut and a $500 child credit would be at the top of the committee’s agenda for the following year. Whether congressional Republicans would succeed in their effort appeared dependent upon whether Bob Dole would capture the White House—which turned out not to be the case. After announcing in August a much anticipated tax plan (calling for the incredibly novel idea of a 15 percent across-the-board tax cut), the Dole campaign fizzled. Notwithstanding heavy doses of what we now know to be the drug Viagra, the Dole candidacy went limp. With Dole’s declining fortunes, the GOP’s hopes of passing the Contract tax bill diminished. Most Republican congressional candidates running for reelection distanced themselves from the faltering Dole campaign. In the end, Bill Clinton easily won reelection, capturing 49 percent of the popular vote to Dole’s 41 percent (with Ross Perot receiving an anemic 8 percent of the popular vote). The 379 to 159 electoral vote was even more lopsided. With 88

The Tax Deadlock Decade Democratic gains in the House and Senate, the radical Republican revolution lost its edge and indications were that 1997 would be another year of deadlock over tax policy. Or would it?

Taxpayer Relief in 1997 The year 1997 began with congressional Republicans picking up right where they left off the prior year—proposing tax-reduction legislation. On January 8, Senate Majority Leader Trent Lott expressed his hope that Congress and President Clinton could agree to tax cuts in the order of $125 billion to $150 billion.38 To get the ball rolling, on the very first day of the 105th Congress, fourteen separate bills were introduced in the House to revise the tax code. Tax reduction was again high on the Republican agenda. As Congress turned to the new budget, tax provisions crowded the legislative docket. Budget proposals offered by both Senate Republicans and Democrats included tax incentives for education, expanded IRAs, reduction in the tax on capital gains, and relief from the estate and gift tax. Indeed, President Clinton’s own 1998 budget package provided $100 billion in tax cuts over five years. Republicans accepted that as a good start, but urged an overhaul of the Internal Revenue Service (IRS) and the entire tax code to boot.39 In January, Senate Republicans released a package of their ten most desired tax items, including some $200 billion in tax reduction over five years. Senate Democrats released their own alternative package, with a more modest goal of $90 billion in tax cuts. The first week of March, House Republicans formally announced their agenda. The plan included reducing, or eliminating altogether, the taxation of capital gains as well as repeal of the estate tax. They also proposed expanded access to IRAs, pension plans, and medical spending accounts. The plan reiterated support for tax simplification and a desire to “audit the IRS” and review alleged IRS abuses.40 By May, Republicans were willing to accept the President’s budget proposals for tax incentives for education in exchange for the White House’s commitment to “meaningful” tax reduction. By June, budget negotiators approved a five-year budget resolution even while the chairman of the Ways and Means Committee began marking up a new tax bill. Soon after, the Finance Committee reported its own tax bill that included $85 billion of tax cuts over five years and $250 billion over ten years. Similar to the proposal that emerged from Ways and Means, the Senate bill included none too surprisingly, Chairman Roth’s favorite proposal: expanded coverage for IRAs. In July, the President unveiled his own package of tax cuts, which included reduction of the tax on capital gains, some relief from the gift and estate tax, expansion of IRAs, a modest child tax credit, and tax credits for college tuition. During the summer, negotiations stalled in the Conference Committee that was 89

The Tax Deadlock Decade trying to work out a compromise over differences between the House and Senate bills. But by the end of the month, Congress passed legislation that would cut taxes by more than $400 billion over ten years. The tax bill (H.R. 2014) passed the House by a vote of 389–93 and the Senate by 92–8. On August 5, even while expressing reservations about its content, President Clinton signed into law the Taxpayer Relief Act of 1997.41 Thus, two-and-a-half years after taking control of Congress, Republicans finally had their first tax reduction bill of any significance enacted into law. The Taxpayer Relief Act of 1997 reads like a Christmas list of special tax provisions targeted at constituents of the Republican party. The legislation reduced the maximum tax on long-term capital gains for individuals to 20 percent (a perennial goal of Republicans since the preferential rate for capital gains was repealed in 1986). It also lessened the burden of the corporate alternative minimum tax and eliminated it altogether for small business corporations.42 The 1997 act increased (over ten years) the exemption to federal gift and estate tax from $600,000 to $1 million, as well as created an entirely new $700,000 exemption for owners of small businesses and farms. The Republican legislation included provisions expanding the availability of Individual Retirement Accounts (IRAs) and creating a new “Roth IRA” (named after Finance Committee Chairman Roth, who was awarded the dubious honor of being the first individual to have a section of the tax code named after him43). Those with savings in old-fashioned IRAs were even given the option to move funds into a new Roth IRA, but at a cost—income tax would be triggered. A very sophisticated analysis of the longterm benefits from switching to a Roth IRA was required. The banks and accounting firms had a field day selling this new “financial product” created by Senator Roth. The negative effect was to create even more confusion for those trying to plan and save for their retirement years. Because any tax bill requires a broad nonpartisan coalition behind it, Republicans were forced to make some concessions to the Democrats. For instance, the Clinton administration lobbied for and got several new education tax credits, a new exemption for $250,000 of gain ($500,000 for married couples) from the sale of a residence, and a number of proposals to shut down “abusive” financial transactions designed by Wall Street investment firms to allow clients to defer gain realized on stock and securities. These provisions had been originally proposed by the Clinton administration in 1995 in response to the GOP’s Contract tax bill, and were included in the 1997 act as a compromise to gain the President’s support (or at least, tacit acceptance) for the bill. Contemporary opinions of the Tax Relief Act of 1997 ranged from enthusiastic (Republicans), to lukewarm (Democrats), to highly negative (tax professionals). From the perspective of the administration of the tax system, the 1997 act was a disaster. Not only was the tax code not simplified, but a good deal of unnecessary complexity was introduced. Specifically, the treatment of capital

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The Tax Deadlock Decade gains on IRS Form “Schedule D” became a nightmare. During the final stages of negotiations over the 1997 bill, at the insistence of Treasury Secretary Robert Rubin, the holding period for the new preferential 20 percent rate for long-term capital gains was raised from 12 months to 18 months. This created a complicated three-tier system under which gains were taxed at three different rates, depending upon the applicable holding period, as well as the classification of the underlying capital asset itself. The apparently simple job of determining a taxpayer’s tax liability for the sale of a capital asset now required a separate worksheet and a much more complicated Schedule D. Likewise, the $700,000 exemption from estate tax for owners of small businesses and farms just introduced a new and complicated tax shelter available to very few taxpayers. The consensus among tax professionals is that the many qualifications placed on the exemption make it much too impractical to be of any real value to small business owners. Also, by creating yet another tax-deferred entity (the new Roth IRA), the 1997 act further complicated strategies and decisions for retirement savings. Several new education tax credits (none of them worth very much, and all of them phased out for high-income families) were also introduced, thereby further cluttering up the tax code. These days, many universities employ full-time personnel to advise matriculating students of the various tax preferences for which they may qualify. This is because education tax credits are popular with politicians, like Senator Charles Grassley of the Finance Committee, who perfectly expressed their perspective: “The tax code is an ideal way to promote education.”44 Unfortunately, the tax code is similarly conducive to promoting farming, industry, investment, marriage, childcare, homeownership—the list goes on an on. In one recent election, a Republican candidate running for Congress in Maryland proposed a bizarre $500-per-year tax credit for pets on the grounds that they “help children not be so lonely.”45 This says a good deal about why the tax code is riddled through and through with special tax preferences. Politicians from both parties find it very easy to propose tax preferences to enact their favorite causes. All the new tax credits proposed by Democratic candidate Al Gore during his bid for the presidency led economist Paul Krugman to quip: “[I]t is an understatement to say that [Gore’s] tax breaks are complicated. As best as I can figure, they are targeted on a middle-income widow with many children, all about to enter college, who does not receive health insurance from her employer, is enrolled in a training program, drives a fuel-efficient car and is about to inherit a farm.”46 In all fairness to Gore, the Republican Congress enacted many tax preferences during the 1990s that are just as complicated and convoluted as what the Vice President was proposing. Only the new exemption for gain realized on the sale of a personal residence contributed anything toward the simplification of the tax laws. With such a generous exemption, most home sales will not likely be subject to tax, and thus

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The Tax Deadlock Decade the burden of record keeping was eased for the vast majority of taxpayers. Of course, this same generous exemption fortifies what are already very strong tax incentives for overinvestment in residential real estate, thereby creating an economic inefficiency in the allocation of resources. Even still, the new statute makes a whole lot more sense than its predecessors in the tax code, a two-year “rollover” provision and a one-time $125,000 exemption for those over 55 years of age.47 In conjunction with the enactment of the new $250,000 exemption, both of these tax preferences were repealed.

GOP Antitax Policy in 1998 The antitax message of the Republican party continued to dominate the national policy agenda in 1998. Members of the antitax wing of the Republican party attracted attention for their cause as they attempted to organize a viable national political movement against the income tax. In 1998, Ways and Means Committee Chairman Archer went off on a speaking engagement across the country to “educate” the public on the need to replace the income tax—whether with the flat consumption-based tax favored by House Majority Leader Dick Armey and GOP presidential candidate Steve Forbes or a national sales tax, championed by Rep. Billy Tauzin of Louisiana and Senator Orin Hatch of Utah. In 1998, House Republicans also intensified their battle with the Bill Clinton. What began with rumors of the President’s involvement with a young White House intern ended with the impeachment of William Jefferson Clinton by the House of Representatives for giving false testimony about his relations in depositions in connection with yet another civil law suit against the President for sexual harassment. It would be a very interesting year for taxes and the presidency! In one particularly brazen act of political grandstanding in June 1998, the House voted 219–209 in favor of the Tax Code Termination Act, which would “sunset” the federal income tax by July 4, 2002. The bill (H.R. 3097) was sponsored by antitax activist Rep. Steve Largent of Oklahoma and cosponsored in the Senate by Majority Leader Lott.48 Amazingly, the proposal left completely unanswered the rather important question of how to replace the $1 trillion of revenue that is raised annually under the income tax. Elimination of the principal source of federal revenue would strike a serious blow to the federal government. Or perhaps that was the point—the bloated post–New Deal, Great Society social welfare state created by liberal Democrats during the past six decades would be cut down at the knees by blowing up its financial foundation. Of course, in the end, the whole affair was really just for show. The House leadership always counted on the integrity of the Senate to invoke such concepts as fiscal responsibility and kill the measure—which mercifully it did. The point of adopting such a bill in the first place (knowing full well that the Senate would defeat it) was simply to promote the GOP campaign for “fundamental tax reform.” The effort 92

The Tax Deadlock Decade may have backfired on the Republicans, as the Washington press corps reacted with a good deal of outrage and cynicism, and the public with considerable indifference, to this overtly political and unseemly use of the legislative power. One thing was certain. The antitax rhetoric of the GOP imposed significant restraints on all policymakers—even Democrats who might otherwise be tempted to raise taxes for the federal government. Indeed, there has been enormous political pressure on all politicians in the United States to reduce taxes even in the face of the significant budget shortfalls experienced in the 1980s and 1990s—a lesson learned all too well by Bill Clinton. Only a few years after his 1993 tax increase, the President sheepishly disavowed his handicraft and accepted a proposal from congressional Republicans for $95 billion of net tax cuts over five years. These were included in the Taxpayer Relief Act of 1997 and the Balanced Budget Act of 1997, both of which Clinton signed into law. The 1997 budget legislation imposed new caps on discretionary domestic spending that would severely constrain the budgetary process for the 1999 and 2000 budgets. The persistence of the deep-rooted antitax ideology expressed by Republicans has also had a significant long-term impact on the development of U.S. tax policy. Ironically, while broad-based tax reduction is a fundamental tenet of the Republican party, and cutting marginal tax rates is dogma to the proinvestment supply-side wing of the GOP, all such tax cuts run counter to what is most advantageous to congressional policymakers qua politicians—namely, tax cuts targeted at their constituents. As much as Republicans like cutting taxes in general, they and their Democratic colleagues qua politicians have a greater interest in granting tax relief to constituents in their home districts and those organized interests and groups that comprise their respective party coalitions. This helps explain why, for all the antitax rhetoric, the 1995 Republican tax bill (vetoed by President Clinton) and the tax reduction legislation enacted in 1997 included so many special tax preferences benefiting constituents of both political parties. Starting in 1997, congressional Republicans turned their attention to the agency charged with administering the tax laws—the Internal Revenue Service. Tapping what they (rightly or wrongly) perceive to be a strong undercurrent of antitax sentiment within the electorate, Republican leaders focused popular discontent with the tax laws on the IRS. Out on the campaign trail, Republican politicians took to blaming the IRS for the excessive complexity of the tax laws (dubbed the “IRS Code”) and the burden of taxation itself—conveniently ignoring that it is Congress that writes the tax laws, and not the administrative agency. In September 1997, Senate Finance Committee Chairman Roth conducted televised committee hearings investigating purported abuses of taxpayers by the Internal Revenue Service. In dramatic testimony, IRS agents (some wearing hoods to conceal their identities) testified before the Finance Committee on the alleged abusive conduct of the agency in its collection activities. The hearings were a great public relations success for antitax Republicans, who viewed the 93

The Tax Deadlock Decade publicity as the first step in a full-scale assault on the income tax itself.49 While these stories appeared on the front-page of newspapers all across the country, reports that virtually all of the allegations made against the IRS proved unfounded went largely unpublicized.50 Soon after the hearings, the Ways and Means Committee approved a bill proposing new safeguards for taxpayers litigating with the IRS and restructuring the Internal Revenue Service (by putting the agency under the control of an independent supervisory board made up of nongovernmental executives). The bill sailed through the House in early November 1997 by a vote of 426 to 4, but then was held up in the Finance Committee by Roth—who promised that the Senate would adopt an even tougher version in 1998. In the spring of 1998, Roth again held Finance Committee hearings investigating alleged abuses of taxpayers by the IRS, but this time there was a much less enthusiastic response from the media and public. Soon thereafter, the GOP proposal to restructure the IRS was adopted overwhelmingly by Congress and implemented under the Internal Revenue Service Restructuring and Reform Act of 1998.51 The Internal Revenue Service Restructuring and Reform Act of 1998 expressed partisan rhetoric and bipartisan constituency service. The initiative emerged from committee as typical grab bag tax legislation as Republicans succeeded in turning the IRS restructuring measure into an omnibus tax bill.52 The central feature of the reorganization plan was a new organizational structure for the IRS based upon classifications of taxpayers (individuals, corporations, tax-exempt entities, etc., rather than the old geographic, regional organization in place since 1952) and the creation of a new independent oversight board. The new IRS Oversight Board comprises nine individuals: (1) six “private-life” members who are not federal employees or federal officials, and who are appointed by the President, (2) the Treasury secretary, (3) the IRS commissioner, and (4) a fulltime federal employee appointed by the President with the advice and consent of the Senate.53 The authority of the IRS Oversight Board is limited to administrative and management issues, and is expressly barred from participating in the development or formulation of federal tax policy.54 It was not until September 2000 that President Clinton actually made his seven appointments to the Board, and the Board itself did not meet until November. To date, little (if anything) has been accomplished by the group. For example, it took the Oversight Board over a month to approve IRS Commissioner Charles O. Rossotti’s nominee for National Taxpayer Advocate—although it was not clear under the Internal Revenue Service Restructuring and Reform Act of 1998 that Board approval was even needed for such appointment.55 The 1998 legislation also included several new taxpayer protections (i.e., provisions expressing the wrath of the GOP for the IRS): provisions that shift the legal burden of proof to the IRS in civil litigation, impose limitations on the power of the IRS to levy a taxpayer’s principal residence, provide a more favor94

The Tax Deadlock Decade able computation of the amount of interest owed by taxpayers on unpaid tax liabilities, and limit the liability of an “innocent spouse” for taxes owed by their spouse on a joint tax return. The bill also created a new privilege for accountants representing taxpayers in tax matters.56 The Conference Committee subsequently modified this privilege, limiting its scope to client representation in civil tax matters before the IRS (but not other government agencies, such as the SEC) and expressly holding that privilege shall not apply in written communications with the taxpayer concerning “corporate tax shelters.” As the wording of the bill originally seemed to also apply to the privilege of lawyers representing their clients, the American Bar Association (ABA) joined the American Institute of Certified Public Accountants (AICPA) in lobbying against the measure. Thereafter, the Conference Committee inserted language making clear that the lawyerclient privilege was not effected by the provision, and applies only to the already limited new accountants’ privilege.57 If the new oversight board has had little effect on the day to day operations of the IRS, the Republican assault on the agency generally had a concrete impact. The morale of IRS personnel dropped as employees became fearful of being fired for violating one of the so-called ten deadly sins—prohibited conduct for which termination is warranted under the Internal Revenue Service Restructuring and Reform Act of 1998.58 Televised hearings of the sort conducted by the Senate Finance Committee in 1997 and 1998 have that kind of effect on those under the gun. Collection of debts owed the IRS (meaning the U.S. Treasury) dropped precipitously as agents sought to avoid lawsuits against them for what might be perceived as overly aggressive collection efforts. To make matters worse, owing to budget restraints placed on the tax collection agency, audit rates for individual taxpayers plunged dramatically.59 All this makes for one troubled administrative agency. In another provision added at the last minute in Conference Committee, the 1998 legislation simplified the multitiered holding periods for long-term capital gains that had been adopted only the year before under the 1997 tax act.60 Tax professionals and taxpayers alike found the system a nightmare of complexity when preparing 1997 tax returns. From July 1997 to July 1998, capital gains were taxed at five different rates (15 percent, 28 percent, 31 percent, 36 percent, or 36.9 percent), depending upon whether the asset sold had been held by the taxpayer less than one year, more than one year but less than 18 months, one year to five years, or more than five years, and depending upon what kind of asset it was (e.g., artwork, business asset, inventory, investment property, etc.). The system was much too complex and entirely unnecessary. For the previous half century, a two-tiered system had worked just fine. After the 1997 tax act, Ways and Means Committee Chairman Archer repeatedly promised to repeal the 18month holding period, and he fulfilled that promise in the 1998 legislation. This reform carried a cost of $2 billion over ten years.61 Archer also attracted attention when he blocked inclusion of a “technical correction” to the 1997 tax act. The drafters of that legislation had inadvertently 95

The Tax Deadlock Decade altered the tax rate structure for the federal estate tax, and thereby reduced the tax burden for those few wealthy individuals with estates greater than $20 million. Archer rejected the technical correction on the grounds that it would implement a “tax increase,” and hence had no place in the Republican bill. Democrats in Congress were apoplectic. House Minority Leader Richard Gephardt (D-Mo.) denounced Archer’s maneuvering to kill the technical correction as an “abomination,” and Senate Minority Leader Thomas Daschle (D-S.D.) fumed. But in the end, silence from the White House left congressional Democrats dangling and undercut Democratic opposition in the Conference Committee. The “inadvertent” estate tax cut stood.62 The 1998 tax act was notable for several other provisions that did not make it into the final legislation. The influence of special interests is often evidenced as much by those provisions that are excluded from a tax bill as by those that are included in the legislation for their benefit. For example, the White House had proposed a revenue-raising provision that would have changed the way life insurance companies calculate reserves, regulated the use of family limited partnerships in reducing federal gift and estate tax liabilities, and eliminated the use of so-called Crummey powers in planning for the gift and estate taxes. All of these reform measures, which had their origins in the Treasury Department, faced strong opposition from well organized business interests—most particularly, the insurance industry. Congressional Republicans succeeded in excluding all three proposals from the final bill. In addition, a proposal to expand the IRS’s electronic filing program via the dissemination of software for tax return preparation was squashed by lobbying efforts from industry giants Inuit and H&R Block—which market their own highly profitable software programs for tax return preparation. In another provision, issuers of tax-exempt bonds challenged by the IRS were given added protections and a new appeals procedures in an amendment introduced by Senator Orin Hatch (R-Utah) for the benefit of a school district in his state that had its bonds challenged by the IRS.63 A Treasury proposal to tax employer-provided meals was opposed by lobbyists for the gaming and hospitality industries, and a greatly watered-down version was substituted—at a cost of $316 million over ten years, as estimated by the JCT. In fact, the final version of the bill actually provided more favorable tax treatment of employer-provided meals than that afforded under pre-1998 law.64 Finally, it was notable that the 1998 bill failed to include even modest relief from the marriage tax penalty. Separate legislation was introduced later in 1998 to take on the marriage penalty, but it never reached the floor. This bogus issue (discussed further in chapter 5) has haunted tax policy since 1994, when Republicans committed to this Contract “reform,” but soon discovered they could not come up with the revenue to pay for any meaningful change in the tax treatment of married couples. Funding for the many revenue losers included in the 1998 tax act (which the Joint Tax Committee scored as costing $13 billion over ten years) was 96

The Tax Deadlock Decade achieved largely through two measures. The first liberalized the rules for converting a traditional IRA into a new Roth IRA for senior citizens earning more than $100,000. (The conversion was scored to raise revenue in the short run because tax is triggered on the withdrawal of savings out of the traditional IRA; however, in the long-run, the conversion costs the Treasury revenue as the funds reinvested in a Roth IRA are afforded more favorable tax treatment. Conveniently, the long-term cost of the conversion shows up outside the 10-year timeframe of federal budgeting.) The second major revenue raiser overturned a much criticized decision of the U.S. Tax Court in Schmidt Baking Co. Inc.65 In that case, the Tax Court had allowed the company to deduct more than $2 million of accrued (but unpaid) vacation and severance compensation that was secured by a standby letter of credit. Legislative repeal of Schmidt Baking was projected to raise some $3.2 billion over five years.66 In a separate legislative initiative during the spring of 1998, the Education Savings and School Excellence Act of 1998 (H.R. 2646), congressional Republicans proposed expanding tax-free IRA withdrawals for qualified educational expenses—including tuition for private elementary and secondary schools. The bill passed both houses and emerged from Conference Committee in June. However, President Clinton threatened to veto the bill (despite having sponsored the educational tax credits included in the 1997 tax act), and as the Republican leadership lacked the requisite votes to override such a veto, the measure subsequently died a quiet death. The GOP was willing to rest content with its success in restructuring the IRS. That turned out to be the highlight for Republicans in 1998. Suffering a serious setback in the November 1998 midterm elections (i.e., the loss of five seats in the House and no gains in the Senate), House Republicans openly questioned their own party leadership—specifically, that of Speaker Newt Gingrich. Soon after the election, it became clear that the Speaker might not have enough votes among Republicans to retain his position. Gingrich had faced a similar challenge to his leadership when the 105th Congress convened in January 1997. He survived that obstacle, as well as a reprimand and $300,000 fine imposed by the House two weeks later for the use of tax-exempt contributions for political purposes and making false statements to the House Ethics Committee investigating him. The House reprimand was followed by an attempted coup in July by his top lieutenants (the two Texans, Dick Armey and Tom DeLay, Bill Paxon of New York, and GOP Conference Chairman John A. Boehner of Ohio), who sought to replace him as Speaker. Again, Gingrich fended off the opposition. However, in the wake of the November 1998 election setback, Gingrich faced an even more serious challenge from Appropriations Committee Chairman Bob Livingston of Louisiana, as well as a much less serious threat from conservative antitax activist Steve Largent, a member of the GOP freshman class of 1995 from Oklahoma. Announcing his own underdog campaign, Largent (a former professional football player) declared: “I think it is abundantly clear that on November 3, the Republican party hit an iceberg. I think the question that is 97

The Tax Deadlock Decade before our conference today is whether we retain the crew of the Titanic or we look for some new leadership.”67 Largent proved correct in his analysis, although he was not the immediate beneficiary of the Republican revolt against the Speaker. In a stunning development on November 6, Gingrich announced that he would not stand for reelection as Speaker and would leave the House at the end of the year. Thus, Gingrich, who ironically had led the successful campaign to unseat Democratic Speaker Jim Wright in 1989, was a victim of an intraparty purge—the revolt of the sons against the father. Soon after, in a bizarre sequence of events, the Speaker heir-apparent Livingston quickly exited the stage after rumors of his own sexual affair surfaced. Republicans turned to a compromise candidate for Speaker, Deputy Whip J. Dennis Hastert, a little-known congressman from Illinois and former highschool wrestling coach. Amazingly, Clinton not only had survived efforts by the radical Republican to remove him from office, he also outlasted two of the most vocal leaders of that campaign.

1999: Another Year of Tax Deadlock Starting back in 1996, the Congressional Budget Office (CBO) began tracking a new trend in the government’s financial condition. CBO was soon suggesting that budget deficits would not be nearly as severe as previously estimated. Slowly, predictions of budget deficits gave way to predictions of surpluses only a few years down the line. As the economy boomed and tax receipts continued to flood into the Treasury, the whole game changed dramatically. In January 1999, CBO predicted a cumulative surplus of $2.6 trillion for fiscal years 2000–2009. Suddenly, after years of dire forecasts of ballooning deficits, CBO was predicting decades of surpluses. Based on CBO’s rosy forecast in January, President Clinton proposed in his 1999 State of the Union address “dedicating” some 62 percent of the projected surplus to Social Security. He also proposed a new $1,000 tax credit intended to induce families to care for elderly or dependant relatives.68 This was part of a broader package of assistance to further long-term care for the elderly. It was just the beginning. The President subsequently announced a slew of other new tax credits intended to implement the White House’s social policy agenda. Included in the package (earmarked for the fiscal year 2000 budget) was a new tax credit for disabled workers; a tax credit to encourage investment in underdeveloped urban and rural areas; a tax credit to induce consumers to buy a new breed of fuel-efficient automobiles; a tax credit for employers who improve adult literacy; a tax credit for the purchase of rooftop solar energy equipment; and another tax credit to encourage employers to retrain blue-collar workers.69 The administration also proposed exempting $2,000 of severance pay for workers and extending the welfare-to-work tax credit for one more year. Finally, the administration 98

The Tax Deadlock Decade proposed a new tax credit to aid the ailing U.S. steel industry. That proposal would allow steel manufacturers to carry back net operating losses (NOLs) for five taxable years, instead of the current two.70 In his January 1999 address, the president also announced an expensive plan for new retirement savings accounts—Universal Savings Accounts. This was his answer to Republican plans for privatizing all or a portion of Social Security. An extra trillion dollars or so goes a long way in bailing out the fiscally bankrupt Social Security system—which is why politicians of all stripes were so anxious that CBO improve upon its earlier economic prediction. Good news is just what they got! First, in late June the Office of Management of Budget (OMB), the White House’s budget agency, issued a fifteen-year forecast predicting an extra $1 trillion on top of the $4.9 trillion surplus that OMB had previously projected for the period. As soon as OMB came out with its revised forecast, President Clinton proposed additional measures to bolster Social Security, as well as expand Medicare by adding new prescription drug coverage for the elderly (the latter, at an estimated cost of $118 billion over ten years). However, while the administration commonly relies on OMB forecasts for new program initiatives, as well as in preparing the annual budget, CBO’s figures are authoritative for the legislative process. Thus, it was important that CBO issue numbers at least as favorable in its July report. Not only did CBO not disappoint, it was even more optimistic than OMB. According to the July report, the budget surplus for the current fiscal year would reach $120 billion—some $9 billion more than what it had predicted only last April, and pretty close to the actual figure of $123 billion for 1999.71 In addition, CBO was now predicting that the cumulative surplus over the next ten years would be nearly $2.9 trillion. Even more significant, the revised CBO figures showed an “on-budget” surplus of $14 billion for fiscal year 2000 and a cumulative on-budget surplus of $996 billion for fiscal years 2000–2009. This on-budget surplus was what got the antitax wing of the Republican party all revved up again! As every politician in Washington knows (although it is often conveniently ignored), CBO’s predictions of budget surpluses are based upon the consolidated budget, which for the past several years has included an extra $125–$150 billion or so generated annually by the Social Security payroll tax. But even disregarding this surplus from Social Security, CBO was now predicting that a tiny “onbudget” surplus from government operations would be realized for fiscal year 1999—nine years earlier than CBO had been predicting only one year before. The political significance of on-budget surpluses, no matter how modest, was hardly lost on politicians in Washington, especially among the antitax wing of the Republican party. Predictions of “off-budget” surpluses never helped their cause very much as any excess cash flow currently generated by the Social Security payroll tax is invested in special U.S. Treasury notes that must be repaid on the 99

The Tax Deadlock Decade day those debt obligations come due. While Congress has always been quite willing to the use the temporary Social Security surplus to finance current government spending, everyone knows that this is money that is owed to the Social Security Trust Fund and must be repaid sometime in the future. (Of course, politicians seldom worry about the “future,” as the “present” usually provides them more than enough problems to wrestle with.) On the other hand, the newly projected trillion dollar on-budget surplus represents a real economic windfall for the federal government—at least, somewhere down the road when, and if, it actually materializes. These funds do not have to be paid back! Even moderate Republicans (and a number of Democrats as well) are perfectly willing to use a projected on-budget surplus to finance a current tax cut. And so the momentum for another Republican tax-cut bill mounted. During the spring of 1999, House Republican leaders worked to craft a new tax bill that would use most of the projected $996 billion cumulative onbudget surplus to dole out a wide range of tax benefits to woo voters in advance of the coming 2000 elections. The GOP House bill, released on July 10, differed in significant respects from that released by the Senate only the day before. The House bill, which provided for $850 billion of tax cuts over ten years, was largely the handiwork of Ways and Means Committee Chairman Archer. Archer recognized that this would be his last chance to deliver on long-promised tax proposals, as the powerful Texas Republican had already announced that he would not seek reelection when his term expired. The House bill included provisions that would grant relief to high-income, two-earner married couples from the marriage penalty (by increasing the standard deduction for married couples to $8,600 from $7,200), further reduce the preferential tax rate for capital gains for individuals (capping the maximum rate at 15 percent), entirely phase out the federal gift and estate tax (over nine years), and ease the burden on individual and corporate taxpayers from the alternative minimum tax. House Republicans also proposed several new “targeted” tax cuts—tax credits and expanded IRA-like savings accounts for educational expenses, including private school tuition, and tax credits for those who care for an elderly relative at home. The latter was the only item likely to appeal to President Clinton, who not only survived his impeachment by the House and subsequent trial in the Senate, but stuck around for the rest of his term seemingly just to torment those conservative Republicans who so deeply despised him. Archer’s original mark included a provision that would reduce the top capital gains rate for corporations from 35 percent to 25 percent—a tax cut long favored by the Republican from Texas. That item was quickly scrapped in an effort led by the new Speaker of the House, Dennis Hastert, to build support for the tax bill among moderate Republicans. The mild-mannered Hastert has deeprooted conservative views, but his instincts are for compromise. This was clearly evidenced in his handling of the tax bill. The exclusion of Archer’s expensive capital gains provision allowed Hastert to include several other items designed to 100

The Tax Deadlock Decade broaden popular appeal and support for the bill. These included expanding existing tax credits for low-income housing and hiring low-income workers. Most prominently, a new deduction was created for the cost of Medicare prescription drug insurance coverage. The latter was contingent upon reaching agreement between the White House and congressional Republicans on a broader plan to overhaul the Medicare program. But the centerpiece of the House bill was an expensive 10 percent acrossthe-board tax cut estimated to cost some $400 billion over ten years. The proposal reduced the top tax bracket from 39.6 percent to 35.6 percent, decreased the 28 percent bracket to 25.2 percent, and dropped the 15 percent bracket to 13.5 percent starting January 1, 2001. In the past, this kind of proposal left Republicans vulnerable to criticism that the main beneficiaries of their tax cuts are the wealthy. Indeed, almost as if on cue, Robert McIntyre, director of the pro-labor Citizens for Tax Justice (CTJ), denounced the House proposal as “unfair” for favoring the wealthy over middle- and low-income taxpayers. In contrast, the bill that Senator Roth presented to the Finance Committee intentionally targeted low- and middle-income taxpayers, proposing a reduction of the 15 percent tax bracket (which at the time applied to taxable income reaching $25,350 for single taxpayers) to 14 percent for tax years beginning January 1, 2001, and gradually raising over eight years the income level for the new 14 percent bracket. The Roth tax bill in total was estimated to cost only $792 billion over ten years. It preserved the capital gains tax rate at current levels—offering instead increased contribution limits for IRAs and 401(k) tax-preferred savings accounts. The Senate bill also offered no new relief from the federal estate tax. Because of this, the more moderate Senate bill was less appealing to the hard-core constituency within the GOP that favored more radical tax cuts, although it had greater bipartisan support. All along the While House indicated that while the President would accept moderate tax cuts (something in the order of $250 billion over ten years), he would not support the Republican bill in its present form. Appearing on NBC television’s Meet the Press on July 11, Treasury Secretary Lawrence Summers indicated that the President would veto either version of the Republican bill, insisting that the bulk of the surplus must be used to bolster Medicare and Social Security, and not fund tax cuts. In many respects, the 1999 campaign for tax cuts should have been a “make or break” issue for the GOP. For the past five years, Republicans in Congress had failed to enact all their most favored tax policies. In September 1998, GOP House leaders had been unable to push through even a modest tax bill that would have provided $80 billion of targeted tax cuts over five years. And remember the Republican response to President Clinton’s 1999 State of the Union address? That too called for a 10 percent across-the-board tax cut—which would have been the largest tax cut since the Economic Recovery and Taxpayer Relief Act of 1981 (ERTA). The proposal fell flat and was dropped like a hot potato. Suddenly in July 1999, with CBO predicting huge surpluses in the years to come, the 10 101

The Tax Deadlock Decade percent across-the-board tax cut reappeared as the centerpiece of the new Republican tax bill. The Conference Committee met to reconcile the Senate and House versions. As it turned out, this required remarkably little effort. Indeed, the conferees threw in several new proposals that were not originally in either the House bill or its Senate counterpart. On August 4, the Conference Committee reported its compromise bill. Surprising even its most enthusiastic supporters, the GOP tax bill sailed through the House and Senate in record time. The very next day, the House passed the Taxpayer Refund and Relief Act of 1999 by a 221 to 206 vote that followed strict party lines. The Senate followed suit by a vote of 50 to 49. The 1999 act was never serious legislation. Because the GOP refused to scale back the magnitude of the tax cuts (the final bill was estimated to cost $792 billion over ten years72), a veto by President Clinton was an absolute certainty. Ironically, the President’s threatened veto just pumped up congressional Republicans, who seized the opportunity to load up the bill with virtually every tax preference and reform proposal ever imagined by the GOP in the postwar era. The bill became a laundry list of everything the GOP would do to the federal tax system—if Clinton was not in the White House and there were no Democrats in the Congress. Of course, Republicans were counting on George W. Bush being elected president in 2000. But no matter what, Bill Clinton would be gone after one more year. On December 1, 1999, the frontrunner for the Republican nomination announced his own tax plan.73 Imposing some $483 billion of tax cuts over five years, Bush’s plan was actually twice as costly over ten years as the ill-fated Taxpayer Refund and Relief Act of 1999.74 Candidate Bush proposed cutting all tax rates, benefiting not only the wealthiest taxpayers, but also the “working poor” and the middle class. The child credit would be doubled and made available to taxpayers with income up to $200,000. Non-itemizers would be allowed a deduction for charitable contributions. Tax-deferred educational accounts would be expanded, the marriage penalty reduced (by restoring the $3,000 two-earner deduction previously repealed in 1986), and the estate and gift tax phased out by 2009. Amazingly, compared to the hard-core antitax candidates Steve Forbes, Gary Bauer, Alan Keyes, and even Orin Hatch, George W. Bush looked like the moderate among GOP presidential contenders with respect to tax cuts! The rest of the bunch was ready to simply jettison the income tax altogether. Instead of sending the Taxpayer Refund and Relief Act of 1999 directly to the White House for the President’s signature (which everyone knew was not forthcoming), congressional Republicans made a tactical decision to sit on the bill. With that, Congress recessed for the summer and Republican members went off to the hinterlands to drum up support for the tax cut among their constituents. What they quickly discovered was that the voters were not particularly keen on tax reduction at all, preferring other uses for the $2.9 trillion surplus that CBO was now predicting. Polls revealed that voters (including Republicans) generally 102

The Tax Deadlock Decade preferred using surplus funds to bolster Social Security and public schools.75 After failing to generate any noticeable public interest for their tax-reduction legislation (let alone the groundswell of support that they needed to overcome the President’ promised veto), Congress finally sent the Taxpayer Refund and Relief Act of 1999 to the White House on September 15, 1999. After waiting so many weeks to receive the bill, Clinton was in no rush to act. Instead, the Democratic president savored the moment and took full advantage of the opportunity to reiterate his opposition to a tax cut of such magnitude, attempting to tarnish the Republican tax cut by contrasting it with other possible uses for the projected surplus funds—most prominently, his own plan to “save” the underfunded Social Security and Medicare programs. Waiting until the last moment for dramatic effect, the President made good on his promise and vetoed the legislation on September 23. Once again, Clinton stopped a Republican tax bill dead in its tracks. During his tenure in office, President Clinton had already vetoed more Republican tax bills than any Democrat, other than Harry Truman. But Clinton still had another year in office to try for the record! The maneuvering of Republicans over the 1999 tax act hardly played out the way they had expected. Rather than exciting the electorate and tainting the political career of the man they despised most in Washington, the battle over the tax reduction legislation seriously damaged the GOP and left Clinton smelling like roses. In many ways, the Republican tax bill was only the sideshow in 1999. The real battle was over the fiscal year 2000 budget, and there too, Republicans took a beating from the President. By the time the new fiscal year began on October 1, only a few of the thirteen appropriations bills that provide authorization for government spending were in place. In dribs and drabs, Congress sent additional bills up to the President for his signature. Because nearly two-thirds of the federal budget goes toward nondiscretionary spending (the so-called entitlement programs of Social Security and Medicare, along with military pensions), the only politically feasible method of reigning in federal spending is cutting back funding for everything else. This puts the squeeze on spending for domestic policy programs, as well as the military.76 In addition, the spending caps on discretionary spending adopted under the 1997 budget agreement imposed even more pressure on negotiators trying to put together a budget.77 As a result, the struggle over the $1.7 trillion fiscal year 2000 budget devolved into a partisan struggle over funding that one-third of the budget that is reachable by elected politicians. To this end, Republicans initially proposed a 1 percent across-the-board cut in spending for all programs, but Democrats rejected that out of hand. The struggle over the budget then disintegrated into a discussion over such petty issues as the optimal number of students per teacher in the classroom (the education bill) and the milk price support system in the Midwest (the agriculture bill). As the Thanksgiving 1999 holiday drew near and members of Congress looked forward to recessing for the year, a compromise was finally reached. A package of the five final appropriations bills was accepted by Republicans anxious 103

The Tax Deadlock Decade to get a budget in place and head home to lick their wounds. Under the compromise, more than $3.2 billion in spending was pushed into the next year’s budget by delaying government paychecks to military and civilian personnel until after October 1, 2000. To appease the White House, an additional $1.3 billion (over seven years) was included in the education bill to hire new teachers, $926 million was earmarked to pay down the government’s debt to the United Nations, and $1.8 billion was provided to implement the Wye River Middle East peace plan brokered by the President. To appease their Republican colleagues, Democrats agreed to a modest 0.38 percent across-the-board spending cut (amounting to some $1.3 billion). The Federal Reserve Board did its part by agreeing to a one-time transfer of $3.5 billion to the Treasury to help close the gap.78 Democratic Senator Herbert Kohl of Wisconsin mercifully dropped his quixotic campaign on behalf of Midwest dairy farmers that threatened to tie up the agriculture appropriations bill. In the end, Republicans were forced to use the on-budget surplus that CBO had predicted for fiscal year 2000 to finance increased domestic discretionary spending. And the spending caps were blown to bits! GOP presidential contender John McCain later criticized his congressional colleagues (including fellow Republicans) for inserting some $1.9 billion in the final package for “special interest giveaways and pork-barrel spending.”79 Accusing members of Congress of slipping pork-barrel spending into the federal budget is a bit like denouncing a hog for excessive piggishness—it’s not very astute as far as observations go. Of course, the Senator from Arizona had spent considerable time campaigning in Iowa and New Hampshire, and perhaps had not had a chance to look over any of the other federal budgets adopted in the 1990s. To be sure, the fiscal year 2000 budget was no aberration. On November 18, the House passed the $391 billion omnibus appropriations bill by a 296–135 vote, and the Senate followed suit on November 19 by a 74 –24 margin. With this, Congress wrapped up the budget of the federal government for fiscal year 2000, providing for $617 billion in total discretionary spending—$36 billion more than the previous year (a 6 percent increase) and $17 billion beyond the “mandatory” spending caps agreed to in 1997 ($36 billion if you count “emergency” outlays not subject to the budget caps, including spending for such emergencies as the census, disaster relief, and national defense). According to CBO’s year-end wrap-up, the $14 billion on-budget surplus predicted for 2000, together with the $37.5 billion on-budget surplus predicted for fiscal year 2001, was gone, and if current spending remained constant, as much as $17 billion of the Social Security surplus would be needed to fund the rest of the government’s operations for the fiscal year.80 That translated into a $19 billion on-budget deficit. So perhaps, the Age of Surplus had not quite yet arrived! Complicating matters for future budgeters was the $11 billion of spending that was deferred into fiscal year 2001 in order to reach the fiscal year 2000 budget compromise. But who worries about what might happen a year in the future? 104

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The Tax Deadlock Decade Certainly not Congress, which sent the budget package to the President and recessed for the year. Clinton signed the measure on November 29, and the federal government finally had its budget. To everyone’s surprise, in the waning days of the first session of the 106th Congress, a $21.4 billion package of “extenders” for expiring tax credits was approved by the House as part of a broader set of amendments to the Social Security program.81 The extenders tax package, known as the Tax Relief Extension Act of 1999 (H.R. 1180), passed the House on November 18 by an overwhelming 418–2 vote, and the Senate gave its strong approval the following day. The President signed the measure into law on December 17.82 In the end, this was the only tax legislation that the Republican Congress could get by the Democratic President the entire year. Of course, the President did not fair so well either in achieving his agenda, failing to secure a hike in the minimum wage or prescription drug coverage under Medicare, or even get an increase in cigarette taxes. While there would be no tax cuts in 1999, at least American business secured renewal of the expiring tax credits. By one estimate, some 76 percent of the total package of benefits in the extenders bill was earmarked for corporate or business taxpayers.83 The most important item in the bill extended the tax credit for research and development for a full five years (instead of the usual one year), thereby giving some measure of certainty to business planning.84 In addition, the credit was expanded to cover research conducted in Puerto Rico. Whether the tax credit actually stimulates research and development is another question.85 Much to the delight of chicken farmers in southern Delaware, Finance Committee Chairman Roth managed to include a provision in the extenders bill that modifies the tax credit for electricity produced from renewable resources (also extended through 2001) to include “poultry waste” as an alternative energy source for the production of electricity.86 That modification of the tax code was designed to keep the lights burning in Delaware, where chickens are big business and Roth faced a tough opponent the next year in his bid for another term in the Senate.87 Finally, the extenders bill included three years of relief for the middle class from the alternative minimum tax (AMT). Horrified by the prospect of millions of taxpayers losing the $500 child credit enacted in 1997 on account of the AMT, Republicans opted to excuse the middle class from the onerous alternative tax regime. As Bill Archer more generously put it: “Middle-income taxpayers can breathe easier now knowing they won’t be hit with an unexpected tax bill.”88 So now the “back-up” tax system that was designed by Congress to limit the tax benefits derived from the countless, mindless tax preferences inserted into the tax code by the same politicians trying to curry favor with special economic and social interests was limited by a complicated special interest provision intended to give relief to middle-class taxpayers (e.g., most voters) who might otherwise lose the benefit of one particularly silly $500 tax credit inserted into the tax code to appease social conservatives who support the Republican party. This final speci105

The Tax Deadlock Decade men of tax legislation from the twentieth century perfectly illustrates how Congress has rendered the tax code a mangled mess of conflicting, confusing, and complicated provisions. So the twentieth century ended with one more abuse of the tax laws for the benefit of politicians running for reelection. Bill Clinton remained in office, the political stalemate between the national political parties continued, and the antitax wing of the GOP failed to achieve any of its major goals. Mercifully, the tax deadlock decade came to an end.

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5

Tax Policy in the Twenty-first Century We need tax relief now. In fact, we need tax relief yesterday. And I will work with Congress to provide it. —President George W. Bush (2001) House Republicans believe tax breaks are the end-all, be-all and cure-all for every social ill we have. Their position is so extreme that I would not be surprised to see them advocate a tax break for Osama bin Laden as a way to get him to turn himself in. —Rep. Lloyd Doggett of Texas (2001) The Republican leadership likes to talk about pulling the tax code up by the roots. But, every year, they just add more fertilizer to it. —Rep. Charles B. Rangel of New York (2002)

President Clinton’s definitive veto in September 1999 of the $792 billion tax cut put forth by congressional Republicans forced them to reconsider their strategy for fiscal revolution. After failing to achieve any of their main tax policy objectives in 1999, congressional Republicans decided to try a new tactic in 2000. Since the campaign for a single, massive tax-reduction bill had failed, the Republican leadership decided that this time they would try introducing the most appealing items off their agenda one at a time as stand-alone legislation. The idea was that individual proposals enacting the most popular tax cuts on their agenda (e.g., relief from the marriage penalty, repeal of the federal estate tax, tax cuts on Social Security benefits, increased contribution limits to IRAs and 401(k) retirement plans, etc.) would have the best chance of avoiding the President’s veto. This logic very much reflected the thinking of more moderate Republicans such as the new Speaker of the House, J. Dennis Hastert. With the election coming in November, the President would be reluctant to stand in the way of these popular tax cuts. Or so the thinking went. However, once again things did not turn out the way Republican strategists planned. Once again congressional Republicans were bettered by the Democrat in the White House. Once again there was no fiscal revolution. 107

Tax Policy in the Twenty-first Century Relief from the Marriage Penalty The first priority for House Republicans in 2000 was to enact tax relief for married couples. The “marriage penalty” arises under the income tax where two individuals marry and file a joint return. Under certain circumstances, they will pay more in total income taxes as a married couple than had they remained single. For most of us, this is just part of the price of joining in holy wedlock with our beloved. But the pro-family elements of the New Right view this as a perverse tax incentive that undermines the sacred institution of marriage. And certainly they are right that it is unwise to enact provisions in the tax code that create economic incentives at odds with our most fundamental public policies and social institutions. Accordingly, relief from the marriage tax penalty emerged as one of the most important items off the Contract with America. Republicans were championing the cause for over five years, and it was now time to deliver. Indicative of the thinking of many Republicans, William Roth, chairman of the Finance Committee, denounced the marriage tax penalty as “patently unfair and anti-family.”1 Reinforcing this moral outrage, the issue was perceived by Republican strategists to be one of the most popular items on their agenda. Since 2000 was an election year, an initiative for relief from the marriage tax penalty commenced as soon as Congress returned from its winter recess. After relatively quick deliberations in February, Republicans on the Ways and Means Committee approved Chairman Archer’s mark of a bill to “fix” the marriage tax penalty. Voting in the committee was strictly along party lines. Soon after, the measure went to the full House, which passed the Marriage Tax Penalty Relief Act of 2000 (H.R. 6) by a 268 to 158 vote. Forty-eight Democrats joined their Republican colleagues in voting for the bill. The House proposed eliminating the marriage penalty by raising the 15 percent tax bracket for married couples and increasing the standard deduction for married couples filing a joint tax return to exactly double the standard deduction allowed single taxpayers. This reform came at a substantial price—some $292 billion over ten years.2 The Senate then took up consideration, at which time the initiative bogged down. Agreement for the specific method of solving the problem could not be reached. Indeed, everyone seemed to have a different notion of what the problem was and how to fix it. The Finance Committee also favored a much less costly approach. The Republican initiative stalled. Later that spring, the issue was again raised. This time a proposal was presented as part of the first of two budget reconciliation bills. In part, this approach was taken to make use of a special ruling in May 1996 by Senate Parliamentarian Robert Dove. That ruling affirmed the use of the budget reconciliation process instituted under the Budget Act of 1974 as a vehicle for moving tax legislation through the Senate. Democrats had previously used the reconciliation process to speed up enactment of a tax measure, most notably in 1975 when Finance Committee Chairman Russell Long pushed a temporary tax cut through 108

Tax Policy in the Twenty-first Century Congress. Now it was the Republican leadership that wished to make use of the reconciliation process to their advantage. Not only does reconciliation speed up the legislative process, it also affords protection from the threat of a Senate filibuster by a recalcitrant minority. This is because only a simple majority (rather than 60 Senators) is needed to limit debate on a reconciliation bill.3 On July 12, 2000, the House passed the new bill, the Marriage Tax Penalty Relief Reconciliation Act of 2000 (H.R. 4810), which was nearly identical to the prior version approved in February. The Senate Finance Committee met in June and began deliberations on the reconciliation bill. Again, the Senate favored a less expensive relief measure—something in the order of $56 billion over ten years.4 Initially, Clinton proposed his own $45 billion relief package, and House Democrats offered a $95 billion alternative to their Republican colleagues. These were all rejected by the Republican leadership. Then, in a dramatic move, Clinton offered to sign the Finance Committee’s $56 billion tax relief bill, but only if Congress would adopt legislation to spend the same amount of money on a new White House proposal to expand Medicare coverage to include payments for prescription drugs. Republicans were not biting. They shrugged off Clinton’s proposed bargain and decided to provoke a confrontation with the President just in time for the fall elections. Thereafter, a less costly compromise bill was crafted by Republicans in conference, and that passed both houses.5 Republicans then held a mock “wedding” reception on the steps of the Capitol Building wherein a bride, groom, and the newly enacted bill were symbolically driven away in a limousine to the White House—purportedly for the President’s signature. If only things were that easy. True, the ball was now in the President’s court. But Republicans should have realized that meant trouble for them, not Bill Clinton. The immediate goal of the Republican leadership was to send their tax relief bill to the President late in July just as the Republican National Convention was opening in Philadelphia. Their expectation was that either he would feel compelled to sign the bill, or else his veto of this pro-family legislation in the bright lights of their highly publicized convention would embarrass the President and aid the Republican campaign. Instead, their timing was off. The legislation was late in making its way to the desk of the President, who did not receive it until the convention was already under way. Thereafter, the President stalled for dramatic effect. Then on August 5, Clinton vetoed yet another Republican tax bill, denouncing it as the “first installment of a fiscally reckless tax strategy.”6 Republicans winced and cried foul. Speaker Hastert accused the President of wanting to “keep the marriage tax hidden” from the American people. “Why else would he wait until after the widely televised Republican National Convention to veto tax relief for working people?” asked Hastert rhetorically.7 Truth be told, the convention was not so “widely televised” as Republicans would have wished—or at least, it was not so widely watched. Most important, the President did not feel himself obligated to fall into the Republican trap, and he did not. Once again Bill Clinton had the better of the Republicans. There was no 109

Tax Policy in the Twenty-first Century groundswell of popular protest against his veto or on behalf of the bill. The Democratic President had yet another chance to bloody their noses in September, as congressional Republicans failed in their effort to override his veto. While all 220 House Republicans voted to override the President’s veto, only 49 Democrats broke ranks, and the tally came up 14 votes short. In defiance, Republican leaders reaffirmed that relief from the marriage tax penalty would remain the cornerstone of their tax plan. Republican presidential candidate George W. Bush denounced Clinton for his veto and declared that if elected president, he would sign such a measure. This left Republicans to sit back and wait for the outcome of the election in November. Certainly, a win by Al Gore would not help them in their battle against the marriage tax penalty—although at least Gore was not Clinton. Any change would be for the better, from their perspective. But only a Bush victory could propel them to victory in their long quest for tax relief for the American family. Republicans obviously convinced themselves that attacking the marriage tax penalty is both right and a good political cause. Opinion polls show some support for the basic concept. Who does not support tax relief for families? However, the polls fail to detect any deep discontent among those filing joint tax returns. This is probably because so many married couples today enjoy a tax bonus when they wed and file a joint return. Indeed, marriage can reduce taxes for a great many couples. The Office of Tax Analysis in the Treasury Department recently estimated that 41 percent of joint filers enjoy a marriage bonus, while 48 percent suffer a marriage penalty.8 Another 11 percent are unaffected by marriage—at least from the tax perspective. Why do some couples benefit and others lose out by marrying and filing a joint return? The issue is much more complicated than Republicans make it out to be, and as to be expected, easy solutions are hard to come by. The marriage penalty results from the collision of several conflicting principles written into the tax code. The first is what liberal economists refer to as “vertical equity”—the notion that those with greater incomes ought to pay taxes at higher rates than those with lower incomes. This is the normative principle behind the graduated (or progressive) rate structure of the income tax, against which conservative Republicans have rebelled since the first income tax was enacted during the Civil War. Under current law, those with the highest incomes pay income tax at a newly reduced maximum marginal rate of 38.6 percent, while those with lower income pay at much lower rates. The problem at hand arises when two individuals with significant income (say $100,000 each) marry and file a joint tax return. Because the tax code treats a married couple as a single economic unit, the couple’s income will be combined and “stacked,” thereby pushing some of their income at the margin into a higher tax bracket. As a result, their total tax as a married couple with $200,000 of joint income will be greater than the sum of what each would have paid as unmarried taxpayers with

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Tax Policy in the Twenty-first Century $100,000 each. This is the marriage penalty that Republicans rightly condemn. The more steeply graduated the rate structure, the greater the marriage penalty. Phaseouts for tax credits such as the Earned Income Tax Credit (EITC), exemptions for dependents, certain miscellaneous itemized deductions and a host of other tax credits and deductions, also compound the problem by indirectly raising marginal tax rates as income rises. Some of these phaseouts are in the tax code to deny wealthy taxpayers the benefit of tax preferences intended for the poor and needy, such as the EITC. Others deny the wealthy the benefit of tax preferences that no one should enjoy, such as the $500-per-child tax credit and the slew of new education tax credits enacted in the 1990s. Still others were designed by politicians looking to disguise tax increases. Such gimmicks add needless complexity to the income tax and wreck havoc with marginal tax rates, making it difficult, if not impossible, for taxpayers to know the rate that will apply to any extra dollars they might earn. When two individuals with separate earnings marry, their stacked income pushes them into a higher tax bracket, potentially phasing out some or all of these tax preferences. This imposes an additional tax penalty on taxpayers who marry. It all can add up to several thousand dollars—perhaps not enough to cause U.S. divorce rates to climb, but a real tax penalty nonetheless. Certainly, you would not intentionally design a tax system like this to discriminate against marriage. However, not all married couples are the same. Some couples have very unequal incomes. For instance, imagine a family where Dad stays home to care for the kids and Mom earns significant income as a lawyer or physician. If Mom has $200,000 of income of her own and Dad has none (since there is no “imputed” income for work performed in one’s own home), their total income tax liability will be less as a married couple than if they were two single taxpayers filing separate returns. For them, marrying and filing a joint return produces a tax savings! Why do some married couples enjoy this tax bonus? The answer is simple. In 1948, the Republican-controlled Congress created a new category (i.e., joint filing) for married taxpayers—precisely to reduce taxes for the “traditional” married couple with one wage earner in the family. The tax rate for couples claiming the new joint status was lowered, resulting in a substantial tax reduction for the majority of middle-class American families. Ironically, Congress’s motive in 1948 for passing the legislation was not to give a tax cut to families, but rather to equalize the treatment of married couples in different states. At the time, an increasing number of states were adopting so-called community property laws that allow couples to “split” their income between them, even while filing separate tax returns.9 The Supreme Court had previously sanctioned this practice in the case of Poe v. Seaborn.10 In 1948, Congress created joint filing to give the same tax benefits from income-splitting to those married couples not living in a community property

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Tax Policy in the Twenty-first Century state. No bad motive here. Federal tax law was pushing states to change their family and property law in a direction that no one really wanted to go, and so this reform of the tax code made sense. Still, by helping married couples, Congress ended up hurting single taxpayers, albeit unintentionally. This was inevitable, as helping married couples can only put single taxpayers in a worse position relative to their married friends.11 Under the new joint filing status created in 1948, married couples paid the same income tax on the same total income, regardless of how the income was earned by the respective spouses. However, single taxpayers thereafter paid exactly double the tax as a married couple with the same income. This was a significant marriage bonus. Or was it a penalty for remaining single? Many single taxpayers saw it as the latter. Never fear! Congress is an institution that responds well to voters who complain loudly, and single taxpayers began to complain with increasing volume. In 1969, Congress enacted new legislation to reduce the inequity of a single taxpayer paying more taxes than a married couple with the exact same total income filing a joint return. What happened? You guessed it. By helping single taxpayers, Congress exacerbated the marriage penalty that affects two-earner couples filing a joint return. Yesterday’s tax reform becomes today’s tax inequity! To ease the problem, the Reagan administration included in the 1981 tax legislation a deduction for 10 percent of the income (up to a maximum of $30,000) of a second earner in a family. The idea was to alleviate the marriage tax penalty, which it did to some extent. However, the two-earner deduction was eliminated in 1986 in the spirit of tax reform. That again exacerbated the penalty on marriage. The marriage penalty has become even more acute in recent decades as two-earner families have become more and more common. The problem is that Republicans refuse to acknowledge that reform intended to reduce the marriage penalty must inevitably hurt others—in this case, the one-earner family and single taxpayers. Deep down, Republicans must know this. That is why, to avoid the potentially politically embarrassing act of rewarding rich two-earner couples and punishing the “traditional” family of Republican lore, both versions of the House bill proposed in 2000 included an additional provision raising the threshold for the 15 percent tax bracket. That would have the effect of giving everyone a tax cut—including single taxpayers! However, two-earner couples who itemize their deductions, rather than claim the standard deduction, would not get very much relief from such a proposal. What about the approach to reform taken in the Marriage Penalty Relief Act of 2000? That Republican bill would not have actually raised anyone’s taxes, but the tax cut was highly selective. High-income, two-earner families would have benefited most under that bill. Why must single taxpayers suffer from legislation designed to help married couples? The answer to that question is also not simple. Another principle to which tax policymakers adhere is “horizontal equity”—the notion that similarly situated taxpayers should be treated equally. In other words, a single taxpayer 112

Tax Policy in the Twenty-first Century with $100,000 of income is supposed to be taxed the same as a married couple (treated under the tax code as a single economic unit) with $100,000 of joint income. Since the married couple has greater expenses (although not necessarily twice those of a single taxpayer), a greater standard deduction is justified. Unfortunately, the principle of horizontal equity is undermined by the graduated rate structure of the income tax. For example, on account of the progressive rates, the single taxpayer with $200,000 of income will pay more than the total tax paid by two cohabiting single taxpayers, each earning $100,000. That is because the single taxpayer’s income reaches into a higher marginal tax bracket than the separate income of the two single taxpayers. At the same time, the two single taxpayers living together outside of marriage with $200,000 of total income will pay less than two married taxpayers earning the same $100,000 each, but filing a joint tax return. And so, round and round it goes! With every reform targeted at one group of taxpayers, some other group is relatively disadvantaged. Congress will keep messing up the tax laws trying to fix the marriage tax penalty until everyone realizes that there is no way to express all these conflicting principles in the same tax code. It must be said that a flat tax rate does the most to eliminate or lessen the basic source of the inequity, but that means abandoning the progressive rate structure of the income tax—something voters have not yet shown a willingness to do. Republicans no longer seem so willing to fight for this “reform” either. (Witness Steve Forbes’s quick exit from the 2000 Republican presidential race and the virtual disappearance of his flat tax proposal with him.) Some propose eliminating the distinction between married and single taxpayers, returning to the original tax system enacted in 1913 wherein the individual (not the family) is the basic economic unit of the tax system. But that would hurt the traditional family with one earner—certainly not a very attractive political option for Republicans.12 In May 2001, the Republican controlled 107th Congress enacted the Economic Growth and Tax Relief Reconciliation Act of 2001, which largely followed the approach to reducing the marriage penalty proposed by presidential candidate George W. Bush. The 2001 tax act (discussed further below) included a provision that reduces the marriage penalty (and accordingly, penalizes single taxpayers with high income) by setting the standard deduction for married couples at twice that of single taxpayers. The benefit of the 15-percent tax bracket was also adjusted to give tax relief to married couples filing a joint return. Unfortunately, this is just another ill-conceived solution to a problem that really does not exist—at least, not as portrayed by Republican reformers. The new legislation, which is projected to cost some $47 billion over ten years, leaves it to future generations to untangle the mess. Does any of this make sense? Not really. Sometimes, it is best to leave things alone and live with some slight inequities in the tax code rather than try to cure every grievance of every taxpayer. As Dan Rostenkowski, former chairman 113

Tax Policy in the Twenty-first Century of the House Ways and Means Committee, once warned: “Fundamental reform almost always runs the risk of making things worse.”13 Republicans have ignored that risk in their rush for a quick legislative fix to the marriage tax penalty. Other Republican Tax Initiatives in 2000 The campaign to eliminate the marriage tax penalty was but one of several initiatives that congressional Republicans advanced in 2000. The other significant program focused on repealing the federal gift and estate tax. That campaign, which made little headway in 2000, but really took off in 2001, is discussed in great detail in chapter 6. There were also several minor tax issues that Republicans pursued during the year, although the impending elections in November cast a shadow over tax policymaking. Everyone understood that the likelihood of any tax bill actually being enacted into law in an election year was slim. Proposals that were overtly partisan or too costly simply would be vetoed by President Clinton, who portrayed the piecemeal tax cuts as no better than the massive $792 billion tax cut that he vetoed the prior year. Still, there appeared to be some basis for bipartisan agreement on a number of issues. At least that might lead to limited tax relief in specific areas. In addition, Republicans perceived that they had several clear winners that the President would not dare oppose in the face of the anticipated popular support for their position—or so they thought. In one ill-conceived initiative, the Republican leadership proposed a reduction in the federal excise tax on gasoline and other petroleum-based products. This tax cut was offered in the context of the soaring price of gasoline experienced during the summer and a similar market fluctuation in the price of home heating oil that was causing concern that winter. However, such efforts to tinker with free markets generally do not sit well with free-market types in the GOP. Surely, if the Democrats had suggested such an attempt to micromanage the national economy in response to seasonal fluctuations in the price of specific commodities, they would have been met (justly) with scorn and derision from Republicans. So it should be no surprise that conservative opposition from within the Republican party itself ended up snuffing out that short-lived initiative. Several minor bipartisan tax bills were actually enacted during the year. The first was a proposal to impose registration requirements on so-called section 527 tax-exempt political organizations. This proposal eventually found bipartisan support.14 Originally, a bill introduced for this purpose by congressman Lloyd Doggett (D-Tx.), an outspoken member of the Ways and Means Committee, was suppressed in committee mark-up by the Republican leadership. But when Senator John McCain of Arizona jumped on the bandwagon, a similar proposal made its way into the defense authorization bill and then all the way to the desk of President Clinton, who ultimately signed the measure.15 This legislation is not trivial. Unfortunately, its importance in regulating abuses of the political process by these tax-exempt entities is likely to be limited. 114

Tax Policy in the Twenty-first Century On the other hand, Congressman Doggett failed in an effort to force Congress to address another of his pet peeves. Doggett was unable to persuade Ways and Means to consider any of his proposals to regulate a new generation of abusive corporate tax shelters. The staff of the Senate Finance Committee met the same fate when they introduced a plan to curb the growing tax shelter industry. At the direction of Chairman Roth and ranking Democrat, Daniel Patrick Moynihan, the staff drafted legislation to regulate the most unsavory practices of shelter promoters, but that bill too never made it out of committee.16 As a result, no tax shelter legislation was enacted during the year, although the Treasury Department did issue a so-called White Paper and new regulations requiring registration by tax shelter promoters and disclosure to the IRS by corporate taxpayers who buy into such schemes. (The problem of corporate tax shelters, and the failure of the Republican Congress to respond to the problem, is discussed further in chapter 7.) The tax legislative process did generate one bipartisan tax bill during the year that is highly indicative of how Congress responds to certain kinds of “nonissue” issues purely for purposes of political grandstanding. In August 2000, the IRS released an internal legal memorandum holding that the parents of a kidnapped child may claim the child as a dependant in the year of the kidnapping, but not in subsequent years while the child remains missing.17 Several members of Congress (both Republicans and Democrats) postured in front of the television cameras, expressing indignation and outrage at the tax authorities for taking such a heartless stance. Of course, the IRS was perfectly correct in its position, as the criteria established in the tax code by Congress for claiming another person (whether a child, parent, or other individual) as a dependent is that the taxpayer must have paid for more than half of that person’s support for the calendar year. Mind you, the IRS has no quarrel with parents who claim a kidnapped child as a dependent in the year of the kidnapping, even if the child is missing for most of the year and the support test technically is not met. However, the Service did draw the line for years subsequent to the kidnapping, asserting that because the parents of a kidnapped child are not supporting the child at all in subsequent years when the child is still missing, they are not entitled to claim the child as a dependent in those years. This is really no different from saying that a parent may not claim a deceased child as a dependent in the years following the child’s death. Sad as the death of a child is, the tax law just does not allow a grieving taxpayer to continue to claim the exemption (worth as much as $2,900 for tax year 2001) for the deceased forevermore. Indignant members of Congress used the opportunity arising from media reports of the IRS’s announcement to lambaste the agency for its supposed callousness. Taking the matter one step further, congressman Jim Ramstad (DMinn.) shepherded a bill through the Ways and Means Committee, of which he is a member, revising the tax code to allow the parents of a kidnapped (but not deceased) child to continue to claim that child as a dependent, as well as claim 115

Tax Policy in the Twenty-first Century any relevant tax credits, in years the child is still missing. President Clinton, ever mindful of popular sensibilities and good public relations, raised no objections and eventually signed the measure into law as part of a package of tax proposals. In one final effort to enact some meaningful tax legislation in 2000, Republicans mounted a campaign to consolidate into a single bill all the various piecemeal proposals that they hawked, but failed to enact during the year. This included proposals to raise the contribution limit for IRAs to $5,000, expand medical savings accounts, and miscellaneous items allowing for increased deductions for health-care expenses. The bill also included a proposal to repeal the “foreign sales corporation” regime from the tax code as mandated by the United State’s membership in the World Trade Organization (WTO). Congress had delayed on this issue all year, and it was now imperative that the United States bring its tax laws into conformance with WTO standards. This provision was intended to achieve that status. At the same time, Speaker Hastert reached agreement with President Clinton to include in the bill several provisions to expand the tax preferences for economically depressed, low-income regions. Socalled empowerment zones were first created in 1993, and now there was bipartisan consensus that they should be expanded. However, in the end, the President and a good number of Senate Democrats found much of the bill objectionable, and it never made it out of the Finance Committee. Instead, at the prodding of Ways and Means Committee Chairman Archer, the provision repealing the foreign sales corporation was enacted as stand-alone legislation (H.R. 4986), which Clinton signed into law on November 15.18 Then late in December, Republicans collected together the various tax provisions for which President Clinton had previously expressed some support. These included provisions to create nine new “empowerment zones” and forty new “renewal communities” eligible for special tax breaks.19 These were packaged with a provision extending medical savings accounts for another two years. In addition, Ramstad’s proposal concerning kidnapped children was thrown in. This package was then attached to the remaining appropriation bills for the fiscal year 2001 budget, which included the annual budget appropriation for the Internal Revenue Service. The whole budget-revenue bill was sent to the President for his signature, and Clinton complied on December 21, 2000.20 Finally there was a budget for 2001 (only eleven weeks late), and Republicans had a tax cut worth more than $25 billion over ten years. It was something, if not exactly what they had hoped for at the beginning of the year. So the 106th Congress closed with little of importance accomplished in the area of tax policy. To be sure, there was no shortage of proposals introduced. There were countless initiatives to radically refinance the American state, as well as petty efforts by Democrats and Republicans alike to reward constituents and special interests with new “targeted” tax relief bestowed through tax credits or deductions. Indeed, by one count, there were 339 bills introduced in the 106th Congress to create new tax credits or deductions, or modify existing ones.21 116

Tax Policy in the Twenty-first Century These included new tax preferences for such noble causes as child care, clean-fuel vehicles, renovating historic buildings, firefighters, bulletproof vests for cops, babysitting by grandparents, purchasing luxury yachts, fishing safety equipment, antiporn software, donating human organs, and even breastfeeding. Mercifully, common sense prevailed in the tax committees, and none of these specific proposals was enacted in 2000. But proponents of targeted tax relief knew that they would get another chance in the 107th Congress, and through persistence and hard work, inevitably some such absurdities will be inserted into the tax code.

Election of 2000 Ironically, the future of the antitax wing of the Republican party became more uncertain following the November 2000 elections. Even with the Republican candidate George W. Bush eventually eking out a victory in Florida and accordingly, the electoral college, thereby securing a place for himself in the White House for four years, the outcome of the election could hardly be interpreted as a victory for the Republican party, the antitax movement, or even for Bush himself (who lost the national popular vote, for what that is worth). After the election, the GOP retained a slim 221–212 majority in the House of Representatives, thereby assuring that leadership positions and committee chairs would remain in Republican hands for at least two more years. This meant that Dick Armey could continue his campaign against the income tax from the pulpit afforded him as House majority leader. However, a number of important figures in the antitax movement in the House did not return to the 107th Congress. Most prominently, House Ways and Means Committee Chairman Bill Archer retired after 30 years in the House. Archer was replaced as chairman by Rep. William M. Thomas of California. A pragmatic moderate on tax policy, Thomas was selected by the Republican Steering Committee over the senior Republican on Ways and Means, Phil Crane of Illinois. Of the two, Crane was the more conservative and more deeply committed to the antitax agenda. Perhaps to appease the party’s Right Wing, in the opening days of the 107th Congress Thomas announced his intention to “work” with the Bush administration on its proposal for a $1.6 trillion tax cut. While reassuring, that expression of commitment was a whole lot less than what Bill Archer would have dished up. Over in the Senate, Trent Lott returned as majority leader. While the Senate ended up deadlocked with 50 Republicans and 50 Democrats (with Vice President Cheney voting in the event of a tie), Republicans retained control of the committee chairmanships in a deal that Lott struck with the leadership of the Democratic party. Under that deal, senior Democrats chaired the Senate committees during the opening weeks of the 107th Congress until the inauguration of Bush and Cheney on January 20, 2001. Thereafter, Republicans took over the chairmanships that they had held for the past six years. Committee memberships 117

Tax Policy in the Twenty-first Century were divided evenly between the two parties. As a result, Lott retained his position as majority leader. Later in February, when tax cut fever mounted in Congress, the Senate majority leader declared that President George W. Bush’s proposal for a $1.6 trillion tax cut did not go far enough! Even still, there was no way to deny that the antitax movement had suffered a major setback as a number of notable conservatives were not returned to the chamber. The ranks of conservative Republicans in the Senate were thinned by the 2000 elections. Most notably, long-time proponent of tax cuts, William Roth of Delaware, was upset in his bid for re-election after serving five terms in the Senate. Roth was defeated by the former Democratic governor of Delaware, Tom Carper. Republicans lost three other important seats occupied by conservatives. Departing from the Senate were Spencer Abraham of Michigan, John Ashcroft of Missouri, and Rod Grams of Minnesota. However, there were a few bright moments for conservatives in the GOP. For instance, Republican George Allen won a Senate seat in Virginia, replacing conservative Democrat Chuck Robb. That win, although having little significance with respect to the ideological composition of the Senate, helped the GOP retain its edge in close votes. In one important change of the guard, the ranking Democrat on the Finance Committee, Daniel Patrick Moynihan, retired after serving four distinguished terms as senator from New York. Moynihan was surely the brightest and best educated person to serve in the Senate in the twentieth century— perhaps ever. He also had more experience with tax policy and social welfare programs than anyone else in Congress. His departure left a huge chasm in the institutional memory of the Senate. That hurts Republicans as well as Democrats. But to make matters worse for the GOP, Moynihan was replaced in the Senate by the former first lady, liberal Democrat Hillary Rodham Clinton. This was not good news for the antitax movement. To compound the problem, the junior senator from New York was joined in the freshman class in the Senate by three other equally liberal neophytes: Jon Corzine of New Jersey, Deborah Stabenow of Michigan, and Mark Dayton of Minnesota. Not only was the Senate now less Republican, it also became a whole lot less conservative. These losses for the antitax movement in the Senate were partially mitigated when the senior Republican on the Finance Committee, Charles Grassley of Iowa, succeeded Roth as chairman. Grassley has been a key player in the GOP antitax movement for two decades, having supported the Reagan tax cuts in the 1980s. Upon assuming the chairmanship, Grassley immediately announced that while he favored the broad-based tax cuts included in the Bush proposal, he was also willing to accept targeted tax breaks, especially for such items as long-term health care and renewable energy. So the Senate Finance Committee remained firmly in the hands of an antitax Republican. However, one-half of his committee was composed of Democrats, most of them committed to a very different tax policy agenda. That made it even more difficult for Grassley and the Republican leadership of the Senate to keep in step with their more radical compatriots in the House. 118

Tax Policy in the Twenty-first Century As if Senate Republicans in the 107th Congress did not have enough problems, they faced one more major dilemma. As they opened the session, their tenuous hold on the Senate (and hence, the hold of Republicans on Congress itself and the entire political agenda) hinged precariously on the continued good health of 98 year-old Strom Thurmond of South Carolina, a former Dixiecrat segregationist who switched party allegiances back in 1964 when he joined the GOP. Everyone recognized that Thurmond’s departure from the Senate prior to the expiration of his term in January 2003 would likely result in the appointment of a Democratic successor by South Carolina’s Democratic governor Jim Hodges. With that the Democrats would assume the committee chairs and leadership positions in Senate. As Republican congressman Tom Davis of Virginia put it: “When it’s a 50-50 Senate, things can change in a heartbeat—anybody’s heartbeat.”22 Even the Republican ace-in-the-hole in the Senate, Vice President Cheney’s vote in the event of a tie, could not overcome such a “change in a heartbeat” that would give the Democrats a 51 to 49 edge in the Senate. In the meantime, the GOP retained its fragile hold over the 107th Congress.

Tax Policy and George W. Bush Following his inauguration in January 2001, George W. Bush continued to insist that he would make good on his campaign pledge to cut taxes by $1.3 trillion over ten years. Or was it a $1.6 trillion tax cut? No one seemed to know the full magnitude of the President’s plan, not even the White House.23 On top of this, many in Congress, including a number of middle-of-the-road Republicans, preferred a more modest tax cut. The Democratic leadership was generally in disarray, and most rank-and-file Democrats recognized that a tax cut of some magnitude was a foregone conclusion. With Democrats in such a cooperative mood, almost everyone in Washington expected Bush to compromise and accept a tax cut in the order of what the House Republicans had been looking for back in 1999 (e.g., the $792 billion provided for under the Taxpayer Refund and Relief Act of 1999 that President Clinton had vetoed). At the same time, lobbyists and probusiness organizations were already gearing up for a major effort to impose their will on the President’s tax cut plan—this despite announcements from the White House that Bush would resist efforts to inflate his broad-based tax cut with special provisions giving targeted tax cuts to business interests. Still, Bush was an untested leader, and his ability to resist the powerful corporate interests within his own party was very much in doubt. For their part, Democrats proposed inserting into any tax-reduction legislation an automatic “trigger” that would allow tax rates to drop only on the condition that the budget surpluses forecast by CBO actually materialized. The idea of a trigger mechanism was also supported by several moderate Republicans, including Senators Olympia J. Snowe of Maine, who sits on the Finance and 119

Tax Policy in the Twenty-first Century Budget Committees, Arlen Specter of Pennsylvania, Lincoln D. Chafee of Rhode Island, and Rep. Amos Houghton of New York, a member of the House Ways and Means Committee. None of them could explain exactly how this mechanism would work. Such legislative gimmicks are usually designed to allow members of Congress to have their cake and eat it too, all without gaining any weight. Is it really a $1.6 billion tax cut if taxes are not reduced unless budget surpluses are actually realized? When would rates actually drop? All at once, after ten years, or year by year? Presumably, taxes would be cut annually, but if the predicted surplus for that fiscal year does not materialize, or is less than that year’s tax cut, the tax cut for that year would be withheld. This kind of “just so” tax cut would wreck havoc on federal budgeting and tax planning, both for private taxpayers and the IRS—which has to prepare some 649 tax forms, schedules, and instructions, as well as 340 publications months in advance of the tax season. Sitting and waiting for the budget figures to come in for the fiscal year, which ends on September 30, in order to determine those tax rates applicable to the tax year that ends December 31 would make it virtually impossible for the IRS and taxpayers to comply with the April 15 filing deadline. Bush and most Republicans in Congress flatly rejected the idea of a tax cut with a built-in trigger. A contingent tax cut is hardly what they had in mind as they waged their antitax campaign over the past decade. Bush stuck to his guns and insisted that his bona fide tax cut would be no less than $1.6 trillion, which he proclaimed just the “right” amount. How he knew this was a great mystery, given the total lack of specifics on what he was proposing and the absence of any official revenue estimate of the cost of his plan. Indeed, it would have been impossible for Treasury or the Joint Committee on Taxation to score his tax plan given the lack of details. Nevertheless, Bush held his ground. He also got a whole lot of assistance in selling his “just right” number from the Congressional Budget Office and Federal Reserve Board Chairman Alan Greenspan. First, CBO released its annual budget and economic report in January 2001. While CBO had predicted a $4.6 trillion surplus over ten years in its midyear report issued in July 2000, it was now forecasting a $5.6 trillion surplus.24 Of this total amount, $2.6 trillion would come from the Social Security Trust Fund. The “off-budget surplus” (i.e., the surplus revenue from Social Security, along with any surpluses from Medicare, the U.S. Postal Service, as well as any of the minor and generally unprofitable trust funds established by the government) is now generally considered “off limits” in Washington. This much Republicans and Democrats seem to agree upon. Presumably, this means that Republicans will not give the off-budget surplus back to the taxpayers in the form of a tax cut and Democrats will not spend it on new programs, such as prescription drug coverage for Medicare. Of course, the off-budget surplus does not just sit in the Social Security Trust Fund. The government borrows any surplus from the trust fund, giving special interest-bearing Treasury debt obligations in exchange. The money borrowed from Social Security is used to fund 120

Tax Policy in the Twenty-first Century other programs, and ultimately, must be repaid out of general revenue. But that is a problem for future Congresses, and as such, is generally ignored in the present debate. In addition to the off-budget surplus, CBO was now predicting that a significant “on-budget” surplus (i.e., the surplus from governmental operations, excluding any surplus generated by Social Security) would be realized over the next ten years. If these surplus funds were left with the government, they would automatically go toward paying down the $5.8 trillion national debt, of which some $3.35 trillion is currently held by the public. Of course, no one really expects that there will be an extra $3 trillion left sitting in the coffers of the Treasury. First, the CBO estimate did not take into account any amount for the Republicans’ tax cut that was already on the horizon, or whatever Democrats will manage to earmark for increased government spending. There is a whole lot of pressure in Washington to use surpluses for both purposes. Witness the burst of extra spending and increased pressure for tax cuts that grew toward the end of fiscal year 2001. Of course, we should not be too surprised that major political battles are waged over $3 trillion. Even in Washington, that is still a pretty hefty sum. In January 2001, George W. Bush got some more good news—this time from Alan Greenspan. Testifying before the Senate Finance Committee, the chairman of the Federal Reserve Board indicated that a tax cut might not be such a bad idea after all to cure the sagging economy. Noting that economic growth was “probably very close to zero,” Greenspan suggested that he had changed his mind about the need for a tax cut. Previously, he had been reluctant to back a tax cut, indicating that interest rate cuts were sufficient to deal with the sagging economy. Even while Greenspan subsequently backed off from his veiled endorsement of the President’s tax plan, he had already given the Bush tax plan a big boost. In an address to a joint session of Congress on February 27, Bush finally laid out his plan for a $1.6 trillion tax cut. Basically, it was indistinguishable from what he had been saying for the past year on the campaign trail: “The growing surplus exists because taxes are too high and government is charging more than it needs. The people of America have been overcharged and on their behalf, I am here to ask for a refund.”25 Unfortunately, the President’s speech provided even fewer details about the nature of that “refund” than his December 1999 campaign plan. His “new” tax plan provided for reductions in the tax brackets, doubling the $500 child credit, relief from the marriage tax penalty, and some form of relief from the “death tax.” In the case of the last, it was unclear whether Bush meant repealing the estate tax outright or merely raising the lifetime exemption—already scheduled to rise to $1 million by 2006. Repealing the estate tax over eight years, as provided for in Bush’s December 1999 campaign plan, was estimated to cost $236 billion. So it would not have come as a surprise if the Bush administration opted for a less expensive alternative, such as further raising 121

Tax Policy in the Twenty-first Century the exemption levels. Many Republicans in Congress were already conceding that full repeal would have to give way to partial relief in the form of raising exemptions. There was even talk among Democrats of raising the individual exemption to $2 million. Whether the White House was willing to so compromise or dig in for a fight for outright repeal of the estate tax remained unclear. Notably, the Bush tax plan did not include any relief from the alternative minimum tax (AMT) for individual taxpayers. Originally enacted by Congress in 1969, the AMT was designed to impose some income tax on wealthy taxpayers who claim so many deductions and credits (in those days, often generated through investments in tax shelters) as to reduce their tax liability to virtually nothing. The AMT is a backstop tax that overrides the regular income tax and all of its countless tax preferences granted by Congress. The problem is that the AMT, currently imposed at the rates of 26 percent and 28 percent, was not indexed for inflation. Accordingly, more and more of the upper middle class is being caught in the grasp of this alternative tax system—many of them completely unaware that it even exists until it actually bites them in the rear end.26 The effect of being subject to the AMT is that a taxpayer loses the benefit of such tax preferences as personal exemptions, itemized deductions such as state and local taxes, accelerated depreciation, and qualified stock options received from an employer. According to the Treasury Department, the number of taxpayers affected by the AMT has already doubled in the past five years to 1.3 million taxpayers and will hit 3.5 million taxpayers by 2002.27 As such, the AMT is expected to generate nearly $6 billion in revenue in 2001. But that is just the beginning. It is estimated that by the year 2011, some 21 million taxpayers will be caught in the grasp of the AMT, paying over $189 billion in alternative minimum tax. To fix the problem would cost about $300 billion over ten years. The expected take under the AMT is reflected in CBO’s five-year budget baseline, and hence is already included in the $5.6 trillion projected surplus. Congress granted three years of shelter from the AMT for middle-class taxpayers under the Tax Relief Extension Act of 1999, but that protection will run out soon enough. At that time, many of the middle-class taxpayers who will receive a tax cut under the Bush plan will suddenly face a tax increase on account of the AMT—not exactly what the average taxpayer (or voter) will expect. In fact, by cutting regular income taxes and increasing the child credit to $1,000, the Republican tax plan will bring an additional 15 million taxpayers under the AMT.28 This led Democratic Senator John Kerry to complain: “It is simply fraudulent to say in this tax bill that we are offering a great number of Americans tax relief when we know that we are pushing millions of Americans into the alternative minimum tax.”29 The problem is, it is just too expensive to fix this problem by permanently repealing the AMT or even raising exemptions so that the tax only applies to the super-rich. That would add too much to the already significant price tag of the Bush tax plan, most of which is attributable to rate reduction. Ironically, a number of Democrats from states with high state and 122

Tax Policy in the Twenty-first Century local taxes (such as New York, Wisconsin, Oregon, Maryland, and Massachusetts) feel great pressure to support AMT reform. This is because taxpayers from their states are most likely to get caught in the grasp of the AMT on account of the deduction for state and local taxes (which is disallowed under the AMT). The double irony is these same states were all carried by Al Gore in the 2000 presidential election and are strongholds for the Democratic party.30 The day after delivering his address to Congress, Bush formally presented his tax plan to Congress along with the outline for his budget for fiscal year 2002. The “White House Budget Blueprint” was relatively modest in most respects. The budget plan provided for an overall increase in discretionary spending (i.e., nonentitlement programs) that would be capped at a stingy 4 percent (in contrast to the 6 percent increases implemented in the three immediately preceding fiscal years). However, spending for education would increase $1.8 billion, more than the 4 percent necessary to keep up with inflation, and the National Institutes for Health would get $2.8 billion more. Of course, if some programs get more than 4 percent, other programs, such as the Energy Department and the Internal Revenue Service, would barely receive any increase over the prior year. Notably, military spending (earmarked at $322 billion) would be barely enough to keep up with inflation. This was particularly surprising in light of Bush’s constant complaint during the campaign that the Clinton administration had cut military spending to dangerously low levels. For Bush to keep the budget in line and give a $1.6 trillion tax cut, the military would have to wait for its new weapons systems. While congressional Democrats and their allies uniformly denounced Bush’s proposed tax cut as too expensive, as well as benefiting only the wealthy, they were quite ready to accept some more “modest” number (something like the $800 billion that Republicans had proposed, and they had rejected, just two years earlier). Equally important, Democrats wanted more of the benefit of the tax cut targeted to middle- and low-income taxpayers. As previously noted, it is difficult to design a significant tax cut that benefits middle- and low-income taxpayers precisely because so much of the revenue raised under the individual income tax comes from the top 5 percent of taxpayers. The bottom 50 percent contributes only 4 percent of the revenue collected under the income tax. The only way to steer the benefits of a tax cut toward the lower income levels, as Democrats demand, is to give those who pay little or no taxes some form of refundable tax credit—in other words, create a negative income tax. The last thing that Republicans had been fighting for all these years was an income subsidy program for the poor. For maximum political clout, the Bush White House always referred to its tax plan as a broad-based tax cut—which is largely an accurate description. But the plan also would go a long way toward lowering taxes for wealthy individuals by effectively repealing most of the 1993 Clinton tax increase, so despised by Republicans. The 1993 tax act was directly targeted at the wealthy by increasing 123

Tax Policy in the Twenty-first Century the top bracket from 31 percent (where is stood after the 1990 budget deal between George Bush senior and the Democratic Congress) to 36 percent, with an additional 10-percent surtax for the super-rich pushing the top bracket to 39.6 percent. The tax plan of George W. Bush proposed dropping the maximum rate for individuals from 39.6 percent to 33 percent—only partially reversing the Clinton tax increase on the wealthy, even while giving taxpayers in the middle and lower brackets a tax cut of their own. Furthermore, Bush stuck to his word and largely excluded “Big Business” from sharing in the benefits distributed through his tax plan. A coherent strategy of appealing to wealthy individuals and small business interests, while holding off large corporate taxpayers with promises of tax benefits in future tax legislation, worked to Bush’s advantage. In the end, large companies backed the President’s tax plan anyway, even without getting very much from the legislation, and groups representing small businesses (in particular, the National Federation of Independent Business and the U.S. Chamber of Commerce) provided “grassroots” support for the campaign.31 Of course, it would have been political suicide for Bush to propose tax cuts only for business and the super-rich. That immediately would have been denounced by Democrats as “class warfare,” conveniently ignoring that their own 1993 tax increase was imposed solely on the wealthy. In their partisan eyes, taxing the wealthy represents “justice” and “fairness,” while reducing the tax burden for the very same taxpayers is nothing more than outright “class warfare.” Democrats could very well argue in their defense that the 1993 tax increase merely reversed the Reagan tax cuts for the rich enacted in 1981. Republicans could then respond that the Democrats started the whole thing back in 1913 when an income tax was enacted to “pillage” the rich, as Senator Henry Cabot Lodge protested at the time. Of course, little would be gained by such finger-pointing, and in any event, few voters would have any idea what they were talking about. While the wheels of policymaking in the Senate turn slowly, the House of Representatives likes to jump right into things—especially when tax cuts are involved. On March 1, just one day after President Bush submitted the outline of his budget to Congress, the House Ways and Means Committee approved a $958 billion ten-year tax cut implementing the main elements of Bush’s rate-reduction plan.32 Bush himself had suggested that Congress wait a few weeks, if not months, to take up the issue of tax cuts only after Bush first had a chance to move on his proposals for education. But congressional Republicans had waited long enough for their tax cut. After eight years of Clinton, and now with a Republican in the White House, their highest priority was tax cuts, not education. They simply could not hold back. Only one week later on March 8, the House took up consideration of the Economic Growth and Tax Relief Act of 2001 (H.R. 3) and quickly approved the bill by a 230 to 198 vote. Republicans held their ranks and voted unanimously for the tax cut, really an accelerated version of the key component of the Bush plan (reduction of tax rates). Ten Democrats joined their

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Tax Policy in the Twenty-first Century side. The bill proposed reducing the lowest tax bracket from 15 percent to 10 percent over six years, and the other tax brackets would similarly be reduced by the year 2006. In early March, Senate Minority Leader Tom Daschle (D-S.D.), House Minority Leader Richard A. Gephardt (D-Mo.), and the ranking Democrat on Ways and Means, Charles B. Rangel (D-N.Y.), presented a $900 billion Democratic alternative to the Bush tax plan. The plan, which looked a lot like “Bush Lite,” provided for a similar (less costly) reduction in the lowest tax bracket, relief from the marriage tax penalty in the form of fixing the standard deduction for married couples at twice that of single persons, raising the estate tax lifetime exemption to $2 million per person, and setting aside $100 billion for additional targeted tax cuts.33 While less costly than the Bush plan or the House tax bill (H.R. 3), the Democratic alternative actually gave a larger tax cut than that included in the Republican tax cut that they and Bill Clinton had denounced only three years earlier. That is how far the debate had already shifted. Of course, antitax Republicans had the exact opposite take on both the Bush plan and the tax cut proposed by the House. Conservatives felt that those plans did not go far enough in reducing taxes. Led by Majority Leader Richard Armey and Majority Whip Tom DeLay, conservatives in the House announced their intention to push for a tax cut even greater than the $1.6 trillion that Bush had proposed. They then unveiled a $2.2 trillion tax cut plan. In addition to rate reductions, their proposal would repeal the estate tax, give relief from the marriage tax penalty (costing $112 billion over ten years), raise contribution limits for tax-deferred retirement accounts, and repeal the alternative minimum tax for individuals. Basically, this was everything that antitax Republicans had ever dreamed of during the past decade. Ways and Means Chairman Bill Thomas promoted the Republican House tax cut on the grounds that it would stimulate the sagging economy. However, such a claim was difficult to support. Because the Senate did not expect to take up consideration of the bill until later that spring (preferring to deal first with the equally contentious issue of campaign financing), it would be impossible to implement the tax cuts before the summer, at the earliest. Furthermore, most of the tax cuts would not become effective under the proposal until after 2001 (with only $5.6 billion in tax cuts scheduled for fiscal year 2001). Under the House bill, only the reduction of the lowest tax bracket from 15 percent to 12 percent would be retroactive to January 1, 2001. In order to stimulate consumer spending as quickly as possible, this retroactive portion of the tax cut could be returned to taxpayers immediately via reduced withholding from their paychecks. This was a scheme that the administration of George Bush senior had tried earlier in the decade. However, because the balance of the tax cuts would be phased in over six years, they could have little immediate impact on the economy. Bush had proposed that the entire tax cut be made retroactive to January 1, 2001, but the

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Tax Policy in the Twenty-first Century House was more cautious and the Senate was likely to be more stingy. This led the conservative, pro-business Wall Street Journal to complain that the House tax plan was “watered down Bush.”34 Watered down or full strength, tax reduction is just not a sufficiently sensitive tool for fine-tuning a $9-trillion-a-year economy. According to Stanford University economist Robert E. Hall, co-author of the original flat tax plan and sometime economic adviser to Republican and Democratic presidents, “You shouldn’t manipulate taxes to guide the business cycle.”35 This was exactly what the House was trying to do. Even if enacted in record time, by the time a tax cut actually takes effect, the economy will likely have already changed course. Tax cuts may otherwise be defensible, but not on the basis of micromanaging the national economy. Most economists today accept that the Federal Reserve Board has a better fiscal tool (e.g., lowering interest rates) for stimulating economic expansion.36 Alas, House Republicans were not listening, nor were they willing to leave it to Alan Greenspan and the Fed to perk up the sagging economy and stock market, which had slipped to a two-year low. The Republicans would have their tax cut, whether to stimulate a sagging economy or merely to give back to the American people “their money.” Either way, they had not waited eight years for Bill Clinton to finally exit the White House in order to pass a measly $900 billion tax cut, as the Democrats now proposed. The right number was $1.6 trillion or more, but certainly nothing less. Since the House was jumping the gun on the budget process by voting for a tax cut before approving the first budget resolution for fiscal year 2002, the House Budget Committee soon went to work. By the end of March, the Budget Committee passed by a strict party vote (23 to 19) a resolution for a $1.94 trillion budget for fiscal year 2002, including $1.6 trillion of tax cuts over ten years and the 4 percent overall growth in discretionary spending that President Bush requested. The tax cuts included the $958 billion that the House had already approved for rate reduction, as well as an additional $400 billion for marriage tax penalty relief (setting the standard deduction for married couples at double that for single taxpayers) and boosting the $500 per child tax credit to $1,000. That left precious little for relief from the estate tax and the alternative minimum tax. The Republicans were learning that notwithstanding a $5.6 trillion projected surplus, you cannot implement every item off the antitax agenda in one fell swoop. Another $2.3 trillion would be set aside under the Republican budget resolution to pay down the national debt over ten years. Excluding that portion of the surplus derived from the Social Security Trust Fund, that would leave no more than $20 billion of the projected ten-year surplus unaccounted for. This led John Spratt of South Carolina, the ranking Democrat on the House Budget Committee to warn: “In the blink of an economist’s eye, that [$20 billion] surplus could disappear.”37 The Republicans were cutting it close, and with the stock market dropping a record 20 percent in the first three months of 2001, many an economist’s eye had already blinked. 126

Tax Policy in the Twenty-first Century Things reached a climax on April 6, when the Senate passed its own $2.2 trillion budget resolution providing for a $1.187 trillion tax cut over ten years and $85 billion in tax cuts targeted for 2001 to stimulate the economy. The vote was 65 to 35, with all Republicans voting for the resolution and 15 Democrats joining them in voting for the tax cut. Moderate Republicans Lincoln D. Chafee of Rhode Island and James T. Jeffords of Vermont were pressured by Vice President Cheney to stick with the GOP on the tax cut, which ultimately they did. However, the two joined with a bipartisan bloc of centrists to demand that the President’s proposal for $1.6 trillion in tax cuts be reduced. Some $450 billion was diverted by the centrists from the tax cut toward increased spending on education and debt reduction, which left both Democrats and Republicans claiming victory. In general, the Senate looked for spending to increase by more than 8 percent— versus the much lower figure of 4 percent proposed by the House. Expectations were that any compromise on tax cuts to come out of the Conference Committee (which would include four Republicans and three Democrats) would be more in the order of $1.3 trillion—a hefty sum, but insufficient to finance the entire slate of Republican tax cut proposals. Unless the centrists could be brought on board, relief from the marriage tax penalty and repeal of the federal estate and gift tax would have to wait. Bush finally introduced specific details about his 2002 budget on April 9, 2001. The President’s budget was $1.97 trillion, slightly less than the budget resolutions passed by both the House and Senate. That would require some belttightening in those agencies and programs not favored by the administration. Of course, Bush stuck with his $1.6 trillion tax cut, which included the reduced tax brackets, relief from the marriage tax penalty, repeal of the gift and estate tax, and doubling the $500-per-child tax credit. The budget also included a few new tax preferences thrown in for good measure. These included a $400 tax credit for out-of-pocket expenses incurred by teachers, a tax credit for those who build affordable single-family housing, a new 15 percent tax credit for solar-powered home water heaters and electric systems, making permanent and increasing the $5,000 tax credit for adoption to $7,500, making permanent the so-called Brownfields tax credit, and extending the numerous tax credits set to expire at the end of 2001. No doubt, Congress would only add to this list of tax preferences, putting greater pressure on Bush to cut back the magnitude of the $1.6 trillion tax cut. The battle over the Bush tax cut would be fought within the broader context of the political wrangling over the 2002 budget. In the end, Bush blinked on May Day. Recognizing that Democrats in the Senate had just enough support from moderate Republicans to block his $1.6 trillion tax cut, he settled for a lesser number—something that would hold moderates from his own party, as well as bring a few conservative Democrats on board. The right number turned out to be $1.25 trillion of tax cuts over ten years, with an extra one-year tax cut of $100 billion designated to come from the current surplus as an immediate “economic stimulus” doled out in 2001. The 127

Tax Policy in the Twenty-first Century Republicans were willing to accept a $1.35 trillion tax cut over eleven years—less than what the President had originally proposed, but still much more than they had believed possible only six months earlier. Within a matter of days, the House and Senate reached a compromise on budget figures that incorporated the $1.35 trillion tax cut and would hold discretionary spending for fiscal year 2002 to an increase of 4.9 percent. This represented an increase of $6 billion over what Bush had proposed in his initial budget. Most of this would be allocated by the House Appropriations Committee to education, science, and public works. Despite this compromise, Republicans still had difficulty passing the necessary budget resolutions, as well as working out the specific details of what would actually go into the tax reduction plan. The leadership was relying on conservative Democrats (such as Senators John Breaux of Louisiana and Max Baucus of Montana) to hold together a bipartisan coalition behind the budget compromise, but their response was tepid, at best. The so-called Blue Dogs (mostly composed of conservative and moderate Southern Democrats) remained generally noncommittal on the Bush budget plan.38 At the same time, most liberal Democrats continued to push for even greater spending on domestic programs and public works, while Republicans continued to resist—at least, with respect to programs favored by the Democrats. To complicate matters, the White House indicated that more money for the Defense Department was necessary. As Senate Budget Committee Chairman Pete Domenici succinctly summarized the untenable situation of trying to contain spending while at the same time granting everyone a special program or two: “There’s no question, the lingering issue will be: Should there be more money?”39 Of course, even without increased authorizations, Congress can always find ways around spending limits in the budget. Just as the spending caps for 2001 were blown to bits by “emergency” authorizations, everyone involved in the budget process understood that the 4.9 percent limit for fiscal year 2002 was really just a floor, not a ceiling. Despite the inevitable partisan dickering, Republicans soon managed to push the budget process forward. The Republican Congress took the first steps toward ensuring that a budget would be in place by the October 1 deadline. The House passed the compromise budget resolution on May 9 by a vote of 221–207, with only six Democrats joining the Republican majority and three Republicans defecting. The Senate followed suit the next day by a vote of 53 to 47, and the fiscal 2002 budget was right on track. Then work on the tax legislation began in earnest, with the tax committees working out the details for what specific provisions would go into the legislation that would actually enact the $1.35 trillion tax cut. It soon became clear that reducing the top tax bracket from 39.6 percent to 33 percent, as both House Republicans and the White House sought, would not fly in the evenly divided Senate. However, a reduction to 35 or 36 percent was acceptable to most Senate Republicans, as well as a handful of moderate-toconservative Democrats who would be decisive in securing passage of the bill.

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Tax Policy in the Twenty-first Century Compromise was also necessary in the Senate on a number of other important items, such as relief from the AMT, the marriage tax penalty, and the estate tax. A tax bill addressing these various issues was drafted by Finance Committee Chairman Grassley and Max Baucus, the ranking Democrat on the committee, and approved by the Finance Committee by a 14 –6 vote. The Grassley-Baucus compromise bill was a hodge-podge of tax provisions complicated by staggered effective dates and hidden expiration dates.40 For instance, some mild relief from the AMT was provided (by increasing the personal exemption under the AMT), but that relief was scheduled to expire in 2006, leaving even more middle-class taxpayers facing the prospects of AMT liability at that time. Conversely, repeal of the estate tax would not fully phase in under the bill until 2011. Likewise, the minor relief provided for the marriage penalty tax would be postponed until 2006. As one commentator cynically observed: “Because politicians are not allowed to spend more than $1.35 trillion on so many tax cuts they want to pass right away, the Grassley-Baucus bill provides tax ‘relief ’ that it takes away after five years, so it can provide other tax ‘relief ’ that doesn’t go into effect for five years.”41 The plain reality was that with a limit of $1.35 trillion of tax cuts implemented over eleven years, Republicans simply could not pass everything off their wish list. Furthermore, Senate tax writers were forced to include a slew of targeted tax credits for education off the wish list of cooperative Democrats, such as Robert Torricelli of New Jersey, to secure their votes on the Finance Committee. The result was a tax bill with enough goodies in it to please all the right interests necessary to secure passage, while at the same time unnecessarily contributing to the complexity of the income tax and further undermining the coherence and integrity of the tax code. The goal of the Republican leadership was to put a tax bill on the President’s desk before Congress recessed for the Memorial Day holiday. However, two major obstacles emerged. First, on the day that consideration of the bill began on the floor of the Senate, Democrats raised dozens of amendments to shift the benefit of the tax cut from the super-rich to the middle and working classes. While none of these actually passed, Democrats were able to stall the legislative process long enough for a much more significant problem to emerge for the Republican leadership. Rumors began circulating throughout Washington that Vermont Senator Jim Jeffords, an old-fashioned liberal Republican in the long tradition of Vermont political eccentrics, planned to defect from the GOP to become an independent (generally intending to vote with the Democratic caucus). This would give Democrats a 50 to 49 edge in the Senate and control of the leadership positions. Rushing to wrap up its business before that happened, the Senate approved the Grassley-Baucus mark-up by a 62–38 vote on May 23— the day before Jeffords officially announced his party defection. In an effort to placate his former co-partisans, Jeffords deferred the effective date of his party switch until after a final vote on the tax bill. So the odds for Republicans getting

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Tax Policy in the Twenty-first Century their tax bill passed still looked promising, even though their long-term prospects for retaining control over the policy agenda were significantly diminished by Jeffords’ pending defection. President Bush admonished the Congress not to recess until after they finished their work. A conference committee was formed to work out details for a compromise bill. Compromise was reached quickly as a tax bill acceptable to both the conservative House and the more moderate Senate was hammered out in a day-long bargaining session on May 25 between Bill Thomas and Charles Grassley, representing the GOP leadership, and Max Baucus and John Breaux, representing the Democrats. The conference committee bill made 441 changes to the tax code, affecting the income tax, estate and gift tax, as well as pension law. These included the creation of a new 10-percent tax bracket effective retroactive to January 1, 2001, thereby guaranteeing a $300 “tax rebate” ($600 for married couples) for most taxpayers who paid tax in 2001. The Treasury was instructed to begin issuing rebate checks by midsummer. The Joint Committee on Taxation estimated that the cost of this instant tax relief would amount to approximately $38 billion in 2001.42 Beyond this, the top rate would drop to 35 percent by 2006, with the other tax brackets (except the 15 percent bracket) scheduled to drop 3 percentage points by 2006. This reduction in the tax brackets, along with the creation of the new 10-percent tax bracket, would carry a total cost of $842 billion over eleven years—by far the greatest component in the tax reduction package.43 On the whole, the conference committee bill (H.R. 1836) generally followed the Senate version. The phaseout of personal exemptions and certain miscellaneous itemized deductions for wealthy taxpayers (enacted in 1990 and often referred to by tax professionals as “stealth” tax increases) itself would be gradually phased out beginning in 2006.44 The doubling of the child credit from $500 to $1,000, proposed by the Bush administration, would take place over ten years, and relief from the marriage penalty tax would phase in over eight years. Contribution limits to Individual Retirement Accounts (IRAs) and employersponsored “401(k)” pension plans would be raised over seven and five years, respectively. The bill that came out of the conference committee also followed the Senate version with respect to the phaseout of the estate tax, as well as the generation-skipping transfer tax. The top rate for the estate tax would be gradually reduced to 45 percent, and then repealed altogether in 2010. The gift tax was retained for gifts in excess of a new $1 million exemption level, but at a reduced rate not to exceed the maximum individual rate under the income tax. The Senate provisions providing tax breaks for education were also retained in the final version, totaling nearly $30 billion over ten years. On the other hand, the Bush proposal to allow taxpayers who claim the standard deduction to deduct charitable contributions was not included in the final bill. Undoubtedly, the most peculiar feature of the legislation was the unusual sunset provision inserted at the end of the bill. Virtually the entire tax bill was set to expire after December 31, 2010. Under the sunset provision, the estate tax will 130

Tax Policy in the Twenty-first Century be gradually reduced over eight years, repealed in the ninth year, and then magically be reinstated in the tenth year at the old 55 percent rate. This was done to keep the $1.25 trillion tax-reduction package from running afoul of the Senate budgetary procedure known as the “Byrd rule,” which requires 60 votes in order overcome a point of order raised against legislation that reduces revenue beyond the ten-year timeframe of budget resolutions.45 While the Republicans had enough votes in the Senate to pass the tax bill, they did not have the 60 votes necessary to survive a point of order. Furthermore, Republicans were also under great pressure to keep down the ten-year cost of the bill. This was accomplished by the slight-of-hand accounting trick of limiting the ten-year cost of the tax cut plan to only the first nine years, with no revenue lost in the tenth year. Of course, this means that the Republican tax cut would only be a temporary tax cut—one that would require another (presumably Republican) Congress to revisit the same political issues and make permanent these policies sometime within the next ten years. The irony is that while conservatives had opposed the idea of moderate Republicans for a built-in “trigger” making the tax cut contingent on budget surpluses, the entire tax cut that they actually passed will automatically expire in ten years regardless of the status of the budget surplus. This was a truly contingent tax cut—one contingent on reenactment by a future Congress. Wasting no time, both the Senate and the House passed the compromise legislation, the Economic Growth and Tax Relief Reconciliation Act of 2001. The votes came during a rare Saturday morning session on May 26—just before Congress recessed for Memorial Day. The Senate voted 58 to 33 in favor of the bill, with twelve Democrats joining Republicans. Only two Republicans, John McCain of Arizona and Lincoln Chafee of Rhode Island, voted against the tax bill. Jim Jeffords voted for the tax cut—his last official act as a Republican. In the House, the bill passed by an even stronger 240 to 154 margin, with 28 Democrats and one independent joining the unified Republican bloc. As expected, President Bush enthusiastically signed the legislation on June 7. This gave Republicans their first major tax reduction legislation in twenty years. Bush and the Republican leadership managed to avoid the grip of budget gridlock and tax deadlock—which loomed ever more ominously on the horizon as Democrats prepared to take control of the Senate following the Memorial Day recess. Most in Washington assumed that it would be much harder for the Bush administration and the GOP to control the political agenda once Tom Daschle assumed his new position as Senate majority leader.46 Nevertheless, the 2002 budget was moving along on schedule, and a major tax cut had been passed within the first five months of the Bush presidency. Leaders of the GOP antitax movement were jubilant at their success in cutting taxes, although some still remained disappointed because the income tax itself survived. In an op-ed piece in The Washington Times, House Majority Leader Dick Armey declared that “we’ve slain the beast of tax burdens,” but he then warned that the tax code is still “an enemy at the gate” lurking “in the shadows, choking innovation and growth 131

Tax Policy in the Twenty-first Century while it grows more complex and unfair.”47 The battle had been won, even if the war was not yet over. All things considered, this was great victory for the antitax movement and a strong start for the new Republican administration.

The Bubble Bursts Notwithstanding the enactment of major tax cuts in May and distribution of tax “rebates” during the summer, the U.S. economy continued to slump. With economic growth virtually zero throughout the second and third quarters (narrowly avoiding recession, technically defined as two successive quarters with negative growth), tax revenue collected by the government fell well below expectations. In August 2001, the Congressional Budget Office issued revised budget projections that took into account these lower collections. CBO now predicted a $9 billion on-budget deficit for fiscal year 2001 and a reduced on-budget surplus of $847 billion for the ten-year period from 2002 to 2011. The consolidated surplus for the ten-year baseline was estimated at $3.4 trillion—$2.2 trillion less than the $5.6 trillion surplus that CBO had predicted only three months earlier in May.48 Of this amount, roughly three-quarters would come from Social Security, which by mutual agreement by Democrats and Republicans was deemed “off limits” for spending and tax cuts. That would leave only an $847 billion ten-year on-budget surplus to play around with—a considerable amount by the standards of the late 1980s and early 1990s, but much less than what had previously been promised. This very significant $2.2 trillion reduction in the projected ten-year surplus was attributable to a combination of the tax cuts implemented by the Economic Growth and Tax Relief Reconciliation Act of 2001 (estimated by CBO to reduce revenue by $1.2 trillion over ten years), spending increases under the 2001 Supplemental Appropriations Act, and reduced revenue attributable to the weakening economy. The first wave of tax cuts implemented under the 2001 tax act failed to produce any discernable impact on the economy, which was expected to remain flat for the rest of the year and then only gradually recover in 2002. However, CBO and the administration remained optimistic. Then things got dramatically worse on September 11, 2001, when the economy and the nation as a whole were dealt a severe blow. The September 11 terrorist attacks on New York City and Washington, D.C., left the nation reeling and pushed the economy into recession. The stock market dropped significantly the week after the attack, when the national markets reopened for the first time since the terrorist attacks. Although the stock markets soon recovered ground and returned to pre-September 11 levels within a matter of weeks, the economy remained moribund. This translated into reduced revenue collected by the government and guaranteed an on-budget deficit for the 2001 fiscal year. In late September, CBO revised its projection of the consolidated 132

Tax Policy in the Twenty-first Century budget surplus for fiscal year 2001, lowering its estimate to $121 billion, down from the $153 billion surplus predicted only one month before in August. Total revenue collected by the federal government was now expected to be $36 billion (or 1.8 percent) less than in the prior year.49 This decline in federal receipts would be the first experienced since the severe recession of 1982–1983. Suddenly, Republicans and Democrats agreed that the government would need to take decisive action. The questions was, What to do? No surprise that Democrats generally advocated increased government spending to both stimulate the economy and aid in the recovery of New York City, while Republicans advanced proposals for a new round of tax cuts. Several Republicans in the Senate, led by Trent Lott, proposed reducing the tax on capital gains in an effort to stimulate investment and perk up the sagging stock market. Fed Chairman Alan Greenspan threw some cold water on that idea, urging a more cautious approach. However, the administration was divided on what the appropriate response should be. White House economic adviser Lawrence Lindsey and other conservatives pushed for a package of permanent tax cuts and pro-investment proposals, including accelerated deductions for capital expenditures, while OMB Director Mitchell Daniels and other moderates in the administration favored an immediate and temporary stimulus that would include additional tax rebates for individuals. In the meantime, antitax Republicans in the House took the initiative and pushed through the Ways and Means Committee a major $160 billion stimulus package of temporary and permanent tax cuts for business. The bill (H.R. 3090) cleared the committee on October 12 by a vote of 23 to 14 that followed along party lines. After some trimming and a few concessions to Democrats, a $100 billion package (dubbed the Economic Security and Recovery Act of 2001) passed the full House on October 24 by a close 216 to 214 vote. Three Democrats joined the Republicans, while seven Republicans voted against the measure. The Republican bill included a broad range of significant tax cuts for business, which had been entirely left out in the first round of tax cuts enacted in May 2001. At the time, the Bush administration had promised pro-business interests that they would be taken care of in a second tax bill; few thought that the opportunity to pass a second round of tax cuts would come so soon. The House bill included provisions that would permanently repeal the corporate alternative minimum tax (AMT) and allow for refunds of all tax paid under the AMT since 1986 (this at a cost of $24 billion over ten years50), extend the current net operating loss carryback period from two years to five years for NOLs suffered after September 11, 2001, increase to $35,000 the deduction for capital expenditures under IRC section 179 and allow a first-year deduction equal to 30 percent of the cost of certain newly acquired business property (together costing $18.2 billion over ten years), and extend a host of business tax credits set to expire at the end of 2001 ($800 billion over ten years). Also, the bill would accelerate the individual tax cuts enacted in May 2001, expand eligibility 133

Tax Policy in the Twenty-first Century for the one-time $300 rebate available to individual taxpayers under the 2001 act, and raise the current $3,000 capital loss limitation for individuals to $4,000 in 2001 and $5,000 in 2002. The ten-year cost of the House bill included $71.2 billion of tax cuts for business, $86.2 billion for individuals, $2.1 billion to extend expiring tax credits and technical amendments. The bill also included $1.3 million in revenue raisers, mostly attributable to a statutory override of the Supreme Court’s decision in Gitlitz v. Commissioner (a 2001 opinion that was highly favorable to owners of subchapter S corporations).51 Democrats generally favored less tax reduction and more public spending—this despite warnings from economists that public investment does not make for an effective short-term economic stimulus.52 What Democrats had in mind was increased spending on infrastructure (e.g., highways, railroads, mass transit, school buildings, etc.), extended unemployment benefits, and increased health insurance coverage. On the other hand, centrists in the House never came together behind an alternative package. A substitute alternative bill offered by Rep. Charles Rangel of New York (ranking Democrat on the Ways and Means Committee) was easily defeated by a 165 to 261 vote, and soon after, the antitax Republicans had their way in the House. The tax cuts they passed were more opportunistic than good economics. Treasury Secretary Paul O’Neill dismissed the House bill as little more than “show business.”53 Even staunch supply-side Republicans questioned the wisdom of enacting this odd package of tax cuts—in particular, the retroactive repeal and refund of corporate AMT.54 After all, there is no stimulus to future investment to be derived from refunding previously paid tax. Presumably, things would be different in the Senate, where the Democrats held a slim majority and control of the committees and leadership positions. The Democratic leadership of the Senate immediately announced support for a more moderate mix of tax cuts and spending measures. But everyone had a different notion of what that mix should be. Finance Committee Chairman Max Baucus proposed a package of temporary business and individual tax cuts (costing $35 billion in the first year of the plan), along with increased unemployment and health-care insurance protection—bringing the cost of the first year of the plan to $70 billion. Liberal Democrat Edward Kennedy of Massachusetts proposed a $71 billion package, which included enhanced unemployment and health-care insurance coverage, $10 billion in public works spending, and only one tax benefit targeted at individuals (a $300 rebate to low-income taxpayers).55 A group of thirty self-proclaimed Senate Centrists, led by Democrat John Breaux of Louisiana, Republican Olympia J. Snowe of Maine, and Independent Jim Jeffords of Vermont, favored tax credits for health insurance in lieu of the direct subsidies proposed by Kennedy and Baucus.56 The Blue Dog Coalition proposed reducing the amount of any tax cut by the cost of the war on terrorism. The ranking Republican on the Finance Committee, Charles Grassley, proposed his own $89 billion package of tax cuts. With all these proposals on the table, the

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Tax Policy in the Twenty-first Century Senate would take its time, debate the issues, and show a greater willingness to compromise than the House had. In the meantime, the administration sent mixed signals. The White House issued a statement on October 24 announcing that President Bush “strongly supported” the GOP House bill. However, in anticipation of the Senate opting in favor of a different mix of tax cuts and spending programs, Bush himself stressed that he was open to a more “bipartisan” approach than that of the House Republicans.57 Of course, the President reiterated his support for all the main tax cuts included in the House bill—the business investment tax credits, repeal of the corporate AMT, and acceleration of the tax cuts for individuals included in the May 2001 tax act. In an October 31 speech before the National Association of Manufacturers, on the very same day that the government announced that the economy shrank at an annual rate of 0.4 percent in the third quarter of 2001, Bush declared with some urgency: “Congress needs to pass a stimulus package and get it to my desk before the end of November.”58 Still, it appeared that the President would compromise. So the stage was set for a deal. The Senate was not going to pass tax cuts alone, and any bill to emerge from the Senate would include spending programs beyond what the House had approved. In the end, a proposal from Majority Leader Tom Daschle brought together a coalition of Democrats and centrists, including Independent James Jeffords and Southern conservative John Breaux. Daschle’s plan would cost $66.6 billion in fiscal year 2002, including $14.3 billion to extend unemployment benefits an extra 13 weeks, $12.3 billion to extend medical insurance for unemployed workers, and $14.2 billion in tax benefits for those individuals left out of the May 2001 Republican tax package. Democrats added a provision to aid farmers ($2.8 billion), which persuaded Jeffords to back the bill. The Democratic plan provided for $19.4 billion in new tax breaks for business (including a one-year, 10-percent depreciation deduction for capital investments and an extension of the NOL carryback period to five years from the current two) along with additional spending on transportation and antiterrorist measures.59 On November 8, the Democratic plan passed the Finance Committee on by a narrow 11 to 10 vote, with Jeffords breaking a party-line split by voting with the Democrats. The Senate immediately took up consideration of the bill the very next day. Democrats planned to couple the stimulus bill with a $20 billion spending bill for homeland security offered by Appropriations Committee Chairman Robert Byrd (D-W.Va.). This would push the total cost of the Democratic bill to nearly $90 billion—closer to what House Republicans had approved. Thinking was that this would give Senate Democrats greater bargaining room in negotiations with the Republican minority. However, things did not work out that way, as Senate Republicans refused to cooperate. Instead, they relied on procedural rules to stall the Democratic bill—this even after Democrats

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Tax Policy in the Twenty-first Century stripped the measure of spending programs to which Republicans most strenuously objected. Democrats were unwilling to make additional concessions to bring the Republicans to the negotiating table, and it proved impossible to move a compromise bill through the evenly divided Senate before Congress recessed for Thanksgiving. Once Congress re-convened in December, negotiations between House Republicans and Senate Democrats picked up again. Senate Majority Leader Tom Daschle offered his own compromise stimulus package costing just under $100 billion over ten years. This was too little for House Republicans and too much for Senate moderates. With the year drawing to a close and the sides still far apart, the President tried to prod Democrats and Republicans to accept a stimulus package providing for added health insurance for laid-off workers and some of the tax cuts in the original House Republican bill. Those efforts failed, as House Republicans passed the $90 billion package on December 20, but the Senate adjourned until January 23, 2002, without taking action on the bill. During recess, there were signs that the economy was improving on its own and a stimulus bill was unnecessary. Furthermore, the Congressional Budget Office issued a report on January 9 criticizing the proposed stimulus provisions as “unlikely to generate large first-year increases in gross domestic product.”60 That undercut the major argument in favor of new tax cuts. Nevertheless, after Congress returned to session, Democrats revived consideration of a scaledback stimulus package. Contrary to most expectations, agreement was finally reached on a compromise package that included: an additional 13 weeks of unemployment assistance for laid-off workers (costing $12.6 billion over five years); a two-year extension of 15 expiring tax credits (costing $12.7 billion over five years); $5 billion of new tax benefits to help revitalize lower Manhattan; a tax deduction of up to $250 for out-of-pocket expenses incurred by teachers for classroom supplies in 2002 and 2003 ($409 million over three years); a new provision allowing businesses to deduct losses incurred in 2001 and 2002 against taxes paid up to five years ago ($4.3 billion over 5 years); and an additional 30 percent depreciation deduction for investments in business assets made after September 10, 2001, and before September 11, 2004. The latter was the most costly item in the stimulus bill, estimated to cost $59.5 billion over five years.61 The House passed the package, dubbed the Job Creation and Worker Assistance Act of 2002 (P.L. 107–147), by a 417 to 3 vote on March 7 and the Senate followed suit the next day by a 85 to 9 vote. President Bush signed the bill on March 9. Unwitting beneficiaries of the economic downturn and the terrorist attacks on Washington and New York City, antitax Republicans had their second major tax cut in less than a year, while Democrats secured increased spending on social welfare. That all of this had little impact on the already rebounding economy was of little concern.

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GOP Campaign to Kill the “Death Tax” [N]o advantage comes either to the country as a whole or the individuals inheriting the money by permitting the transmission in their entirety of the enormous fortunes which would be affected by such a tax. —President Theodore Roosevelt (1907) [I]nherited economic power is inconsistent with the ideals of this generation as inherited political power was inconsistent with the ideals of the generation which established our Government. —President Franklin Roosevelt (1935) [T]he estate tax is a monster that must be exterminated. —Senate Majority Leader Trent Lott of Mississippi (1997)

Throughout the 1990s, Republicans talked about repealing the federal estate tax, along with the federal gift tax and the so-called generation-skipping transfer tax. The campaign finally began to bear fruit in the twenty-first century. For example, on June 9, 2000, amid much hoopla, the U.S. House of Representatives voted by a lopsided margin of 279–136 to repeal the estate tax. While the legislative initiative was orchestrated by the House Republican leadership, 50 Democrats joined as cosponsors and 65 actually voted for the bill. A few Democrats even attended a pep rally held on the steps of the Capitol Building prior to the vote to kill what Republicans, on the advice of their pollster Frank Luntz, now derisively refer to as the “death tax.” The Death Tax Elimination Act of 2000 (H.R. 8) would have phased out the estate tax over ten years and carried an estimated price tag of $20 billion over five years, $105 billion over ten years, and about $50 billion a year thereafter. Later that summer, the Senate approved the bill and sent it up to the White House. As expected, President Clinton vetoed the Republican legislation. In September, the House came up 14 votes shy of the two-thirds majority needed to override the President’s veto. Thereafter, Republicans took the issue out on the campaign trail in an effort to drum up additional support for their cause. 137

GOP Campaign to Kill the “Death Tax” Any chance of the Republican effort succeeding would have to wait until Bill Clinton left the White House. GOP presidential candidate George W. Bush pledged his support for the effort to repeal the estate tax. True to his word, the new President proposed relief in the tax plan that he presented to Congress on February 27, 2001. The exact details of the President’s proposal were fuzzy, but he was definitely on board. That gave new life to the campaign against the estate tax. A partial victory was achieved in May when Congress enacted the Economic Growth and Tax Relief Reconciliation Act of 2001, which provided for phasing out the estate tax over nine years—after which the estate tax would be repealed, and then reinstated under the bizarre sunset provision that applies to most of the tax provisions in the bill. In addition, the gift tax was retained for inter vivos (lifetime) transfers in excess of $1 million. Such gifts will be taxed at the current maximum rate for the income tax. So Republicans did not exactly get their entire wish fulfilled. Likewise, Republicans understand that there is plenty of time for Democrats to regain control of Congress, as well as the White House, and reenact a new version of the estate tax even before the old one actually expires on December 31, 2009. Still, for the time being, antitax Republicans had good reason to celebrate their triumph.

GOP Crusade to Repeal the Estate Tax The Republican crusade to repeal the federal gift and estate taxes (which in 1976 were combined into a single “unified” tax on all transfers of wealth) can be traced to the 1994 Contract with America electoral campaign, although Republican opposition to wealth transfer taxes in general goes back to the Civil War. After the GOP took control of Congress following the November 1994 elections, countless bills were introduced to modify or eliminate the gift and estate tax. Surprisingly, despite strong support within Republican ranks, the campaign did not bear fruit in the 1990s. True, several efforts came close. Before the Death Tax Elimination Act of 2000, Republicans passed the Taxpayer Refund and Relief Act of 1999, which also included a provision that would have phased out the estate and gift taxes. But that omnibus revenue package (which implemented a hefty $792 billion tax cut over ten years) was never serious legislation, as President Clinton made it known early on that he intended to veto the bill. Republicans were then free to include every item off their wish list of favored tax proposals—including repeal of the estate and gift taxes. So for all their storm and thunder, Republicans failed to kill the gift and estate tax in the 1990s, although they provided some modest relief for the upper middle class. This was achieved through the negotiations and compromise with the White House that produced the Taxpayer Relief Act of 1997. That legislation included a provision that increased the individual lifetime “exemption” from the wealth transfer tax from $600,000 (where it had been stuck for a decade) to $1 138

GOP Campaign to Kill the “Death Tax” million over ten years. For 2001, the exemption was set at $675,000 and scheduled to rise to $700,000 in 2002 and reach $1 million in 2006.1 The 1997 act also created a new $700,000 exemption for owners of small businesses and family farms— who already enjoy numerous special breaks under the estate tax, such as the ability to pay estate taxes in installments over years and “special-use” valuation that only takes into account the current use of the property (i.e., as a farm) rather than market value.2 Most tax professionals believed that the new $700,000 exemption was so complicated and difficult to comply with that few taxpayers would ever be able to take advantage of the provision.3 (That is now a moot point since the Economic Growth and Tax Relief Reconciliation Act of 2001 repealed the exemption effective as of 2004.) On the other hand, raising the individual exemption to $1 million definitely will eliminate the tax for a significant number of citizens—all but the wealthiest 1 percent of the population. However, even this failed to appease conservatives committed to outright repeal. Because it was always clear that Bill Clinton would veto any Republican bill to repeal the estate tax outright, the legislative initiatives that began in 1995 were merely the GOP’s opening gambit. The endgame began the day George W. Bush moved into the White House, and success was achieved in May 2001 when the 107th Congress voted to phaseout the estate and generation-skipping transfer taxes and substantially modify the gift tax. Who led this crusade during the past six years? Conservative antitax Republicans have been in the forefront of the movement. In the House, Rep. Jennifer Dunn of Washington has played point-guard, sponsoring the Death Tax Elimination Act and other legislative proposals for repeal. Likewise, Christopher Cox of California has played a prominent role in the House, introducing legislation every session to eliminate the tax. Cox is head of the Republican Policy Committee and has had strong support among younger, more conservative members. His efforts have also been supported by the Conservative Action Team, comprised of nearly 70 conservative House Republicans. Surprisingly, a small number of House Democrats joined the choir. Among the most vocal has been Rep. Nick Rahall of West Virginia. Rahall opposes the estate tax because of its purported impact on the small, family-owned businesses and farms in his district. This seems to be the common concern that brings together Democrats and Republicans on this issue: pandering to the misplaced fears, concerns, and votes of owners of small businesses and farms.4 Even Senate Majority Leader Tom Daschle once introduced a bill (cosponsored by fellow Democrat John Breaux of Louisiana, a member of the Finance Committee) exempting the first $900,000 of a family-owned business from estate tax. In 2000, Rep. Charles Rangel of New York, senior Democrat on the Ways and Means Committee, introduced an alternative to the Death Tax Elimination Act. Rangel’s bill would have provided an extremely generous $4 million exemption for small businesses and family farms, as well as reduced by 20 percent the maximum tax on wealth transfers. This compromise proposal was soundly defeated by a 196–22 vote on the same 139

GOP Campaign to Kill the “Death Tax” day that the Republican bill passed. Nevertheless, the fact that Rangel introduced it at all shows just how far Democrats moved on this issue. Still, most Democrats resisted outright repeal. Certainly the key player behind all GOP legislative initiatives in the House was Bill Archer of Texas. Soon after he become chairman of the Ways and Means Committee in January 1995, Archer committed one hundred percent to the campaign to repeal the wealth transfer tax. At the time, Archer stated that he was “philosophically opposed” to estate taxation as a form of “double taxation.” At the June 2000 pep rally against the death tax, Archer declared: “This tax is wrong. It is unfair. We’re going to make it right.”5 By that, Archer meant repeal it. But the 2000 offensive would be Archer’s last chance to make good on his promise to kill the death tax, as he had already announced that he was not running for reelection. Nevertheless, other antitax Republicans on the Ways and Means Committee (most prominently, Dunn and Kenny Hulshof of Missouri) were eager to pick up the cause following Archer’s departure from the House, and so the campaign continued. Over in the Senate, there has also been no shortage of support for repealing the wealth transfer tax. In recent years, Jon Kyl of Arizona constantly introduced legislation to achieve that end. Senators Phil Gramm, Spencer Abraham, Kay Bailey Hutchinson, Rod Grams, and Richard Shelby joined in cosponsoring Kyl’s many legislative initiatives. Other backers include Richard Lugar and Strom Thurmond—both of whom introduced their own proposals to repeal the gift and estate taxes. Key to success in the Senate has been the support of Trent Lott. Back in March 1997, Lott joined fellow Finance Committee member Charles Grassley of Iowa in sponsoring the legislation that raised the individual exemption to $1 million. At the time, Lott declared that “the estate tax is a monster that must be exterminated,” although he lamented that revenue constraints then prevented its outright repeal.6 That was still back in the days of projected budget deficits. But with new estimates from the Congressional Budget Office of trillions of dollars in surpluses over the next 10 years, Lott and other key players in the Senate (such as Grassley on the Finance Committee) moved to support outright repeal. All indications were that the campaign to repeal the federal wealth transfer tax would have a strong chance of succeeding in the 107th Congress. Certainly, all the prerequisites for repeal were in place—a Republican in the White House, a handful of Democrats in Congress willing to go along, and a $5.6 trillion surplus projection to compensate for the revenue that would be lost by repeal. Most important, congressional Republicans remained dedicated to the cause with a religious fervor. The campaign took one giant step forward when a provision to repeal the estate tax made its way into the compromise tax bill that was part of the fiscal 2002 budget. Success for the Republicans was achieved when Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001. The

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GOP Campaign to Kill the “Death Tax” estate tax, along with the generation-skipping transfer tax, is now to be phased out over ten years. What is it about the wealth transfer tax that has always provoked such a strong reaction among antitax Republicans? The answer to this question requires an understanding of the history and nature of the tax.

History of Wealth Taxation in the United States Prior to the enactment of the modern estate tax in 1916, the United States had only sporadic and limited experience with wealth transfer taxes. However, the first such tax actually goes back to the earliest days of the Republic, well before there was a federal income tax. Upon the recommendation of a special revenue committee of the House of Representatives, Congress enacted the first federal inheritance tax under the Stamp Act of July 6, 1797.7 The stimulus for adopting this new tax was the severe revenue shortfalls experienced by the new national government, rather than any ideological impulse to “soak” the rich or redistribute wealth in the new Republic. The tax was imposed through a system of federal stamps, which were required on the receipt and distribution of property from “legacies.” For legacies with values between $50 and $100, a stamp of 25 cents was required; for legacies between $100 and $500, the tariff was 50 cents; and on legacies greater than $500, the duty was $1. The statute granted an exemption for bequests to wives (although not to husbands), children, and grandchildren. A stamp of 50 cents was imposed generally on the probate of wills and the issuance of letters of administration.8 The Stamp Act was highly unpopular among the wealthy, both in the North and the South, as would be all subsequently enacted wealth transfer taxes. Responding to pressures and agitation against the inheritance tax, a coalition of Federalists from the North along with Southerners from the new Jeffersonian Republican party secured repeal of the tax in 1802.9 Thereafter, the national government did without any form of direct taxation of the citizenry for more than a half century. It was not until the revenue crisis occasioned by the Civil War that the national government again experimented with the direct taxation of wealth. First, a federal income tax was adopted by Congress in August 1961 during the first year of the Civil War, and soon after, a wealth tax was introduced. The Act of July 1, 1862, imposed a national gift tax, as well as an inheritance tax on receipts of property in the form of legacies.10 Like modern inheritance taxes typically imposed by state governments, the federal gift tax of 1862 was imposed on the beneficiaries for the privilege of receiving property from the decedent, regardless of the form of such “legacy.” Thus, the tax applied to both bequests (personal property) and devises (real property). Gifts taking effect upon death were includable in the decedent’s estate, and hence subject to

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GOP Campaign to Kill the “Death Tax” tax. The tax applied only on personal estates in excess of $1,000 and was imposed at rates ranging from 0.75 percent on legacies from lineal descendants and siblings, to 5 percent on distributions from unrelated persons. Grants to a spouse were exempt under the inheritance tax of 1862. As the Civil War continued, the Northern government faced a deteriorating revenue position. While public borrowing and the new income tax provided most of the revenue for the war effort, there simply was not enough. Politicians were forced to scramble for revenue wherever it could be found. As described in chapter 1, this led to the rapid expansion of the new income tax that was enacted in 1861. Likewise, the 1862 inherence tax was increased significantly in 1864.11 In addition, the act of 1864 imposed a new “succession” tax on the transfer of real estate by devise. Thus, a full-scale and reasonably sophisticated system of wealth taxation was enacted during the Civil War. However, all forms of wealth taxation were strongly opposed by conservative Old Guard Republicans in the Northeast. Following the war, the crisis of revenue eased and pressure by Northern Republicans to repeal the wealth tax picked up stream. Soon after, the inheritance and succession taxes were repealed under the Act of July 14, 1870.12 For forty years following the repeal of the Civil War inheritance and succession taxes, there was no federal wealth transfer tax of any kind. However, there was a growing movement among those who advocated using a system of progressive income taxation and wealth transfer taxes to impose a more egalitarian economic order. Populists and agrarian parties embraced the graduated income tax, following the lead of the more radical Communist parties of Europe. The federal income tax was finally resurrected in 1894, largely at the instigation of Populists, who by then exerted considerable influence within the Democratic party. While no new inheritance tax was adopted at that time, gifts and bequests were includable in income to the beneficiary under the income tax of 1894. In other words, there was no separate gift or inheritance tax, but income tax was imposed on the receipt of a gift or bequest. This is in contrast to a gift or inheritance tax, which taxes the donor for the privilege of transferring property to another, or an estate tax, which imposes a tax on the value of the decedent’s property at death (regardless of who gets the property). In either case, beneficiaries take the gifted property net of any wealth transfer tax paid by the donor or his estate. With income tax imposed on a gift or bequest, the beneficiary takes the property and then has the legal obligation to pay the tax on the fair market value of the property received. These early wealth transfer taxes never amounted to anything more than supplemental sources of revenue to which the government turned in times of crisis. Typically, the wealth tax would be repealed as soon as the revenue crunch eased. For example, the United States again enacted a death tax in an effort to raise new revenue during the Spanish-American War. The War Revenue Act of 1898 imposed a tax ranging from 0.74 percent to 15 percent on the value of the decedent’s personal property.13 The tax included a generous exemption for the 142

GOP Campaign to Kill the “Death Tax” first $10,000 in the estate, and there was an exemption for transfers to a spouse. This estate tax was subsequently repealed in 1902 as revenue requirements of the American state declined following the war.14 The estate tax of 1898 followed the typical pattern for wealth and income taxation in the nineteenth century: the tax was enacted during a period of extraordinary demand for revenue, and then withdrawn when that particular revenue crisis eased. In the twentieth century, the pattern changed only to the extent that wealth and income taxation was never completely withdrawn, although tax rates were always reduced somewhat following the period of high revenue demand. Thus, demand for revenue, rather than egalitarianism, explains the cyclical pattern that characterizes these taxes. This is not to deny that there were strong ideological pressures exerted by those who favored using inheritance, estate, and income taxation to effect a radical redistribution of wealth in the United States. However, these generally were marginal voices in American politics. The mainstream politicians (Democrats and Republicans alike) who controlled the congressional committees that reported all of the legislation enacting the various wealth taxes of the period were mainly motivated by the need to raise revenue to finance the government’s activities—most particularly, paying for the military engagements of the American state. Revenue pressures, rather than egalitarian politics, motivated those who actually adopted the various wealth taxes experienced in the United States. The exception that proves the rule is the highly progressive wealth transfer tax proposed in 1906 by President Theodore Roosevelt, who declared in support of the measure: “[N]o advantage comes either to the country as a whole or the individuals inheriting the money by permitting the transmission in their entirety of the enormous fortunes which would be affected by such a tax.”15 The proposed tax would limit the amount that an individual could transfer to any other person. No legislative action was ever taken on Roosevelt’s proposal.

The Modern Estate Tax The war that began in Europe in 1914 had a dramatic impact on both the American economy and federal revenue receipts. Even before the United States entered the war, the volume of trade with Europe dropped off precipitously. As a consequence, corporate profits declined, as did revenue raised by the tariff. This in turn put increased pressure on policymakers to expand the new and very modest federal income tax that had been enacted in 1913. The tax rates imposed under the income tax of 1913 were raised dramatically starting with the Revenue Act of 1916. In addition, policymakers enacted a new federal estate tax under the Revenue Act of 1916. The estate tax of 1916 was imposed at the rate of 1 percent on taxable estates in excess of $50,000, rising to 10 percent on estates greater than $5 million. A gift tax, which applies to lifetime transfers of property, was subse143

GOP Campaign to Kill the “Death Tax” quently adopted in 1924 as a backstop to the estate tax—which otherwise can be easily evaded by giving away assets prior to death. The 1916 estate tax was the precursor of the modern estate tax that is still in place. Indeed, the current system of wealth transfer taxation has retained the same basic structure and features of the 1916 estate tax and the 1924 gift tax. With American entry into the war in April 1917, the need of the federal government for revenue exceeded all initial expectations and estimates. In fact, the cost of the first full year of American participation in the war amounted to $26 billion—more than the total cost of operating the entire federal government from 1791 through 1917.16 This explosion in expenditures had a major impact on the national budget. The 1916 effort to raise new revenues proved inadequate, and a new tax bill began to take shape early in 1917. This legislative initiative produced the Revenue Act of 1917,17 which again dramatically raised rates for the income and estate taxes. The top tax rate was raised to 25 percent on estates above $10 million. Soon after, the Revenue Act of 1918 increased rates to historic highs on large estates. However, once World War I ended, the debate over wealth transfer taxation was revived and the opposition reorganized. During the period of “normalcy” of the 1920s, rates were eased considerably. While the Revenue Act of 1924 retained the estate tax at a maximum rate of 40 percent, and also added a new gift tax, exemptions were raised, and the rates imposed on the average estate were quite modest. The 1924 act also introduced a credit against the federal estate tax for state death taxes paid by the decedent. This “soak up” credit is now an essential revenue source of many state governments.18 The cyclical history of wealth transfer taxation in the twentieth century closely parallels that of the income tax. Both taxes were significantly expanded during World War I, and then reduced again during the peacetime of the 1920s. With the onset of the Depression during the final year of the Hoover administration, the exemption for the estate and gift tax was lowered to $50,000 and tax rates reached a maximum of 45 percent on estates in excess of $10 million. To be sure, the populist egalitarianism that characterized the early years of the New Deal also had a dramatic impact on both the income tax and the estate and gift taxes. In 1934, the progressive estate tax reached a maximum rate of 60 percent on estates over $10 million, and in 1935 the top rate was raised to 70 percent. Likewise, the exemption for gift and estate tax was reduced to just $40,000. These tax increases were as much driven by ideology as the government’s need for revenue. Even more dramatic rate increases were enacted during the revenue crisis occasioned by World War II. Immediately prior to the outbreak of war, a 10 percent surtax was imposed on the income tax as well as the gift and estate taxes.19 During the war, the top rate for the estate tax escalated to 77 percent on estates in excess of $50 million.20 Other modifications in the basic structure of the wealth transfer tax regime were made in 1942 and 1948. This ebb and flow of tax rates reflects a combination of factors. Most important, revenue demands during periods of military crisis (as well as eco144

GOP Campaign to Kill the “Death Tax” nomic crisis, such as the Depression) put extraordinary pressure on policymakers to increase tax rates on both income and wealth. On top of this, outbreaks of populist sentiment in American politics, such as that expressed during the 1880s and 1890s, during the New Deal, and periodically thereafter, exert strong pressures on policymakers to increase wealth transfer taxes even in times of peace. Following World War II, rates were lowered slightly, but not nearly by as much as they had been raised during the military crisis itself. Consequently, since the end of the war, wealth transfer taxes in the United States have been among the highest in the world. Currently, the 55 percent maximum tax rate for the federal estate and gift tax trails only that of France (70 percent) and Japan (60 percent) among the developed nations.21 Most other countries impose inheritance taxes, rather than estate taxes. Furthermore, the trend elsewhere has been to reduce, or even eliminate wealth transfer taxes altogether. Canada and Australia have both recently repealed all forms of wealth transfer taxation. In an effort to improve the administration and functionality of the wealth transfer taxes, Congress has continually made adjustments and modifications to the tax system. Some of these changes have been minor, and some more noteworthy. For instance, Congress significantly restructured the estate and gift taxes in 1976, integrating them into a single unified tax imposed at the same rate on lifetime and testamentary dispositions of property. This was the most important change in the structure of the wealth transfer tax regime since the 1920s. Under the new system of wealth transfer taxation, each individual was granted a single lifetime credit in the amount of $47,000 (for transfers made after 1980). That credit was sufficient to shelter the first $175,625 of assets transferred either by gift during the donor’s lifetime or under a will at death. The amount that could be transferred between spouses free of tax was also increased under the 1976 act. In addition, a new “generation-skipping” transfer tax was added to the wealth transfer tax regime in 1976. This tax was intended to reach transfers that skip a generation, such as assets placed in trust for the benefit of a donor’s grandchildren. Without the generation-skipping transfer tax, such a transfer could avoid the imposition of one level of tax that otherwise would be due upon successive transfers among the three generations (i.e., on the transfer from the second to the third generation). The effect of the generation-skipping transfer tax is to impose some tax on the “skip transfer.” These and several other facets of the gift and estate tax were again modified under the Economic Recovery Tax Act of 1981. In particular, the maximum wealth transfer tax rate was reduced from 70 percent to 50 percent over a fouryear period. Also, the marital deduction was made unlimited under ERTA, while the lifetime unified credit against transfer tax was increased over six years to $192,800, thereby exempting up to $600,000 of assets from taxation. There the lifetime unified credit remained frozen, preserving the exemption at $600,000, until it was raised under the Taxpayer Relief Act of 1997 so as to shelter up to $1 million of assets. After ERTA, modest changes to the wealth transfer tax regime 145

GOP Campaign to Kill the “Death Tax” were made under the Deficit Reduction Act of 1984, which delayed the rate reduction, and thereby preserved the top rate at 55 percent. The Tax Reform Act of 1986 also made some important changes to the gift and estate tax. Most notably, TRA replaced the modest 1976 generation-skipping transfer tax with the current system, which imposes the maximum estate tax on skip transfers as if the property transferred had been passed from the donor to his child (the second generation), and then from the child to the grandchild (the third generation). However, the new generation-skipping transfer tax provided a separate very generous $1 million per donor ($2 million per married couple) exemption for transfers to any “skip” generation beneficiary, thus rendering the tax irrelevant for all but the wealthiest taxpayers. Other less significant technical amendments were made to the estate and gift tax under the tax legislation enacted in 1987, 1988, 1989, and 1990. The top transfer tax rate of 55 percent was retained by the 1993 tax act. The 1997 tax act increased the exemption to $1 million. Despite these changes, the basic structure of the wealth transfer tax regime was largely unchanged after 1976. This is the wealth transfer tax that the current generation of antitax Republicans targeted for extinction.

The Politics of Wealth Transfer Taxation The debate over the wealth transfer tax has always been politically divisive and highly ideological. This is because the burden of wealth transfer taxes such as the federal gift and estate tax invariably falls mostly upon the wealthy, thereby pitting the wealthy against middle- and low-income taxpayers. As such, wealth transfer taxation is a case of the majority using the instruments of government to impose a very high tax on a very small minority (who happen to be very wealthy). In opposition, conservative Republicans have generally carried the banner on behalf of the wealthy, while liberal Democrats have largely defended the current wealth transfer tax regime. As to be expected, the political issues are contentious and the rhetoric is highly charged. Liberals defend the estate tax out of a gut reaction feeling that the richest among us should not be allowed to pass their fortunes on to their descendents without paying some sort of toll charge. Liberal supporters argue that the wealth transfer tax serves a basic redistributive function. This is not always so openly admitted with respect to the federal income tax or the benefit payments made under the Social Security program (as opposed to the regressive payroll tax). One recurring metaphor found in eighteenth-century liberal political thought is reference to life as a “race.” Everyone begins the race of life at the same starting point, but on account of the unequal distribution of natural talents and endowments, some inevitably reach the finish line ahead of others. The liberal case for some sort of wealth transfer tax follows this logic, arguing that without the estate tax,

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GOP Campaign to Kill the “Death Tax” the children of those who have accumulated great wealth over their lifetimes will begin the race of life with a decided head start over everyone else. The various arguments in favor of wealth taxation restate this general theme: preventing the transfer of the accumulated wealth of one generation to the next, dismantling dynastic concentrations of wealth within a single family, and generally introducing some redistribution of wealth via the progressive rate structure of the estate and gift taxes. Of course, even at a rate of 55 percent, the wealth transfer tax is incapable of completely breaking up concentrations of wealth in the hands of the likes of billionaires Bill Gates, Ross Perot, or Warren Buffet. Wealth transfer tax or not, the descendants of those whose fortunes are counted in billions will still start the race of life way ahead of everyone else. Nevertheless, there is some overall equalizing of societal wealth on account of the tax. Michael J. Graetz, law professor at Yale Law School and former Deputy Assistant Secretary for Tax Policy in the Treasury during the Bush administration, expressed this classic liberal argument for retaining the wealth transfer tax in his 1983 law review article, “To Praise the Estate Tax, Not to Bury It.”22 Graetz concluded that for all its faults and inadequacies, the estate tax adds a measure of progressivity to a tax system that otherwise does remarkably little to redistribute the inequality of wealth in the United States. Graetz estimated that about one-third of the progressivity of the tax system as a whole is attributable to the estate tax. Others similarly argue that the estate tax has been reasonably effective in checking the concentration of wealth in the United States.23 Of course, conservatives oppose the estate tax on precisely the same grounds. They argue that those who work hard their whole lives should be able to pass on the fruit of their labor to their descendants. They also complain that the accumulated wealth of the family was already taxed once when it was earned, and hence should not be subject to a second-level of tax when it is transferred to the next generation. On one level, this argument is perfectly correct. There is “double” taxation of transferred wealth. The wealth was initially subject to the income tax when it was earned. There even is triple taxation in many cases as the earnings of corporations is taxed at the corporate level and then again at the shareholder level when distributed in the form of a dividend. On the other hand, critics conveniently ignore that a substantial portion of transferred wealth has traditionally escaped income taxation altogether. This is by virtue of the last great loophole left in the tax code—the longstanding policy to forgive income tax owed on a decedent’s unrealized capital gains. This is accomplished through a “step-up” to fair market value in the tax basis of assets held at death.24 Because of this, all the built-in capital gain inherent in the assets is wiped out at death and never taxed. This allows appreciated assets to be transferred from one generation to the next without anyone paying any income tax. At the same time, under a long-standing statutory exclusion, property received by gift or bequest is not

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GOP Campaign to Kill the “Death Tax” included in income by the recipient.25 So literally, no one pays income tax on the built-in gain. By way of illustration, imagine that the family business is owned by Dad. This could be a simple case where Dad directly owns the business assets as a sole proprietor or indirectly through his ownership of the stock of a business corporation that owns the assets. (An example of the latter would be Bill Gates’s stock ownership interest in Microsoft Corporation.) In most cases, Dad’s initial investment in the business was very low, and this is reflected in his low tax basis in the business assets (or his stock, as the case may be). Considerable gain would be realized by Dad on a sale of the business (or his stock). In the event of a gift of the business or stock to his children, the beneficiaries would take a “carryover” basis in the gifted property, and thus the beneficiary would assume the tax liability. However, if Dad dies holding his ownership interest in the business, all the gain inherent in the business assets (or stock) will be wiped out upon his death. Beneficiaries take their bequest at its “stepped-up” fair market value. The same rule applies for all of his other investments and property held on the date of death. Dad’s estate will owe no income taxes on this gain, and the beneficiaries will take their bequests free and clear. Of course, the fair market value of the business is included in Dad’s gross estate, and hence may be subject to estate tax. This important income tax loophole was repealed under the Revenue Act of 1976, but before the effective date of that legislation and in the face of strong lobbying, Congress reversed course and left the basis step-up in the tax code. So if the wealth transfer tax was eliminated without repealing the basis step-up rule, a good deal of the billions of dollars in wealth accumulated by Mr. Gates and his cohorts during their lifetimes would escape taxation altogether. It is one thing to argue that the government should not confiscate the wealth accumulated by one generation through double taxation, but it is quite another thing to allow such wealth to escape taxation entirely! Of course, conservatives have campaigned to repeal the gift and estate tax precisely because it is a significant source of progressivity in the tax system. Ironically, some unlikely liberal voices have joined conservatives in expressing reservations about the use of the estate tax to redistribute wealth. Most prominently, Edward McCaffery, a law professor at the University of Southern California Law Center and self-professed liberal, has challenged the orthodoxy that a liberal state should have some form of a wealth-transfer tax. In a series of widely read articles, McCaffery presents the “liberal case” against the estate tax.26 He concludes that by the very premises of liberal political theory, the current wealth transfer tax is unwarranted and contradictory. Specifically, the estate tax encourages consumption and inter vivos gifts, while at the same time discouraging work and saving by the rich—hardly the goals of classical liberalism. In particular, McCaffery takes on Harvard philosopher John Rawls, who in his seminal work, A Theory of Justice (1971), justified an inheritance tax on the grounds that it was needed “not to raise revenue . . . but gradually and continually to correct the 148

GOP Campaign to Kill the “Death Tax” distribution of wealth and prevent the concentrations of power detrimental to the fair value of political theory and fair equality of opportunity.”27 Rawls goes on to allow for the transfer of wealth from generation to generation, but only under circumstances that satisfy his criteria for social justice: “[I]nheritance is permissible provided that the resulting inequalities are to the advantage of the least fortunate and compatible with liberty and fair equality of opportunity.”28 In other words, the wealthy are allowed to pass on their wealth, but only if they leave it to the poor. Rawls’s argument is just nineteenth-century Populism dressed up in academic garb. But no matter, the real problem is that the estate tax accomplishes none of the objectives that Rawls seeks to achieve. The estate tax is not very effective in redistributing wealth and only has a marginal impact in breaking up concentrations of wealth that pass from generation to generation. On top of that, it is easy to evade and unpopular even among those who are exempt from its grasp (i.e., those who would actually benefit from whatever redistribution of wealth it effects). Finally, while Rawls expressly states that the justifications for wealth transfer tax are not related to revenue concerns, historically the federal gift and estate tax was enacted for that very reason, and it also has been retained in the face of strong Republican opposition precisely because of the revenue it brings in. This further indicates how far the gift and estate tax is from its liberal ideal. Beyond challenging liberal assumptions about the estate tax, McCaffery favors a consumption tax over the current income tax, which of course is really a hybrid system with many of the features of both consumption and income taxes. McCaffery argues that the income tax also violates basic principles of liberalism, while a consumption-type tax (with a moderately graduated rate structure) is more fully consistent with those principles. For example, a consumption tax encourages saving while discouraging (by taxing) consumption by the wealthy, which is socially optimal. Furthermore, because a consumption tax is itself the equivalent of a wealth tax, there is no justification for retaining the estate tax once we replace the income tax with some form of a consumption tax. “[E]ven if we are concerned about the possession of wealth, the present income-plus-estate tax seems ineffective both in theory and practice.”29 Antitax Republicans need look no further than liberal Professor McCaffery for the philosophical foundation for their broad-based attack on the entire U.S. tax regime.

Wealth Transfer Taxation and Revenue Notwithstanding the highly charged ideological nature of the current debate over repealing the gift and estate tax, revenue, rather than ideology, motivated those who originally created our federal wealth transfer taxes. Like the modern income tax enacted in 1913, an estate tax was adopted by Congress in 1916 to supplement revenue from the tariff—the main source of revenue for the federal 149

GOP Campaign to Kill the “Death Tax” government during the nineteenth century. The income tax and the estate tax have been with us ever since. But there is one major difference between the two taxes—the latter has not raised very much revenue in recent decades. Unlike the individual income tax, which replaced the tariff as the major source of revenue for the federal government during World War I and now raises over $1 trillion annually, the estate tax has never contributed very much to the U.S. Treasury. Since 1945, the tax has been an inconsequential source of revenue that affects very few citizens. However, the amount of revenue raised by the gift and estate tax is predicted to increase significantly in coming years, and hence the whole question of repealing the wealth transfer tax regime is more complicated than simply getting rid of an inefficient tax that raises little revenue. To understand why, it is necessary to comprehend how the tax works. The estate tax is imposed on the “gross estate” of an individual at death, less certain allowable deductions and exclusions. The gift tax is imposed on transfers of property during the lifetime of the donor. Under the law prior to the 2001 act, the tax kicked in at 37 percent on taxable estates (or transfers by gift) above the $675,000 exemption and reached 55 percent on estates over $3 million.30 (Under the 1981 tax reduction legislation enacted during Reagan’s first term, the top rate was scheduled to drop to 50 percent in 1993; however, the 1993 Clinton tax legislation put an end to that and preserved the 55 percent top rate. Under the Economic Growth and Tax Relief Reconciliation Act of 2001, the top rate is now scheduled to decline to 45 percent before the estate tax is repealed effective January 1, 2010.) Even at these rates, the gift and estate tax together raised only $29 billion in 2000, only slightly more than in 1999.31 Of this amount, about one-half came from fewer than 3,000 estates valued at $5 million or more, and over 20 percent came from a few hundred estates valued at $20 million or more. This is why it is possible to raise exemption levels to free the middle class from the tax, without significantly reducing the revenue raised by the estate tax. The $29 billion the wealth transfer tax raised in 2000 amounted to less than 1.5 percent of total federal receipts for the year—an increase from the record low of 0.8 percent in 1988, but still an insignificant source of revenue. With exemptions scheduled to increase and rates to decline over the next 10 years under the 2001 Republican tax act, even less revenue will be raised by the estate tax. Some conservative economists, such as Alan Reynolds of the Hudson Institute and William Beach of the Heritage Foundation, claim that the estate tax has a negative impact on revenue collection under the income tax—perhaps enough to offset whatever is collected under the estate tax.32 The argument is that the wealth transfer tax causes property owners to transfer their assets to charities, universities, and other tax-exempt entities that do not pay income tax. As a result, the government loses revenue from the income tax that it would have collected if the wealth transfer tax did not produce a reallocation of resources. If the revenue lost to the government under the income tax exceeds what is collected under the gift and estate tax, the latter would be entirely inefficient and 150

GOP Campaign to Kill the “Death Tax” hardly worth keeping.33 That view is disputed by others who call into question the magnitude of the negative revenue impact on the income tax. Some defenders of the wealth transfer tax discount the negative impact of the estate tax on national savings and revenue collection, as well as debunk grossly inflated estimates of the administrative and compliance costs of tax.34 Far from being an inefficient tax that ought to be eliminated, they conclude that the wealth transfer tax is generally working, notwithstanding its many flaws and loopholes that allow considerable revenue to escape taxation. Their advice: Close the loopholes and leaks, rather than abolish the tax. Of course, closing those loopholes is no easy task, as the IRS knows so well. Whatever the magnitude of the negative impact of the wealth transfer tax on income tax receipts and the cost of administration, it is clear that the wealth transfer tax itself does not raise significant revenue at this time. However, it would be a mistake to use the insignificance of the tax as a source of revenue as an excuse to repeal it. This is because projections are that this will change dramatically as the “Baby-Boomer Generation” starts to retire in the next decade or two. At that time, revenue raised under the gift and estate tax will increase significantly. The Joint Committee on Taxation estimated that revenue from the tax (based on the rate schedule in place prior to enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001) will rise to $35 billion by the year 2007, and increase to $50 billion annually thereafter.35 Those lucky investors who made their fortunes in the stock market during the 1990s would be the source of significant tax revenue in future years as they begin to die off. So even if the short-term revenue cost of repealing the wealth transfer tax does not seem to be much, the long-term cost will be much greater. Measured with respect to its impact over ten years, repealing the estate tax is a much more expensive proposition. In addition to this tax revenue that will be lost by repealing the wealth transfer tax, additional revenue will be lost under the income tax as well. As opposed to the negative impact of the wealth transfer tax on the income tax that conservative economists such as Reynolds and Beach point to, there also is a positive impact on collections under the income tax. How does repeal of the wealth transfer tax cost the Treasury revenue under the income tax? Basically, the gift tax prevents those taxpayers in the highest brackets from transferring assets to their children, who are in lower tax brackets. This is known as “income shifting” and always has been a problem under the income tax. While there are well-developed legal doctrines, as well as statutes that the IRS relies upon to police these kinds of practices, the gift tax serves as a major impediment to income shifting. The toll imposed on the transfer of assets by the gift tax is generally enough to put an end to such tax-saving techniques. Once practitioners and tax experts in the government began to fully comprehend and reveal how repealing the gift and estate tax would enhance opportunities for reducing federal income tax, the Joint Committee on Taxation was forced to reevaluate its 151

GOP Campaign to Kill the “Death Tax” estimate of the cost of repeal, taking into account “behavioral responses” (i.e., income tax avoidance schemes) that would result in lost revenue under the income tax. In a March 2001 memorandum, the JCT concluded that repealing the gift and estate tax would cost as much as $662 billion in revenue from the income tax over ten years.36 In other words, repealing a tax that raises only $30 billion a year would cost the Treasury about twice as much revenue overall. This is what forced Republicans to retain a modified version of the gift tax even after repealing the estate tax pursuant to the 2001 tax act. The wealth transfer tax itself presently raises so little revenue because so few individuals are subject to the tax. This is because of the generous lifetime exemption provided to each individual. In 1976 (the last year before the estate tax was integrated with the gift tax), the exemption was only $60,000. In that year 7.65 percent of all estates (or 139,000 deceased individuals) were subject to the estate tax. Starting in 1981, the exemption was gradually raised to $600,000 over a six-year period, where it remained frozen until Congress enacted the Taxpayer Relief Act of 1997. In 1987, when the exemption reached $600,000, fewer than 19,000 individuals (or about 0.87 percent of deceased adults) were subject to the estate tax—the historic low. From 1987 to 1997, a greater percentage of the population faced estate taxation as inflation eroded the value of the $600,000 exemption and the rising stock market increased the value of estates. Even still, an average of only slightly more than 1.0 percent of all adult decedents were subject to estate tax during this period. The number of estates subject to the tax reached 2.03 percent in 1998 and is expected to remain in the range of between 2.0 to 2.5 percent over the next 10 years, even with the individual exemption rising to $1 million in 2002. On account of the exemption under current law, individuals with taxable estates of less than $1 million and married couples with joint estates below $2 million, need never pay any gift or estate tax. On top of this, another important exemption from the gift tax (which applies to transfers made during the donor’s lifetime) allows individuals to give up to $11,000 a year to any other individual completely free of gift tax. Every December, accountants and tax lawyers all across the country remind their wealthy clients to made these tax-free gifts to their children and grandchildren. By making the gifts, their own taxable estates are reduced and more of the family’s assets are passed on to the next generation without transfer tax. The biggest challenge for married couples is to make these annual gifts and arrange their assets (and draft their wills) to take advantage of each spouse’s lifetime unified credit. There are a number of time-honored techniques for achieving this. The most important is using a “credit shelter” trust in each spouse’s will. This simple device can save a couple’s heirs over $200,000 in estate tax—well worth the extra legal fees paid for properly drafted estate documents. Such techniques for minimizing estate tax are commonly portrayed by the media as loop holes used by the wealthy to “avoid” estate taxes.37 But using trusts 152

GOP Campaign to Kill the “Death Tax” and making $10,000 gifts annually is not only legal, this is what is demanded by the tax laws. This is precisely how Congress has told American citizens to organize their financial affairs in order to comply with the estate tax. And compliance includes making use of those exemptions granted under the law. This is not an abuse, although it is highly unproductive and expensive. The cost of compliance includes estate and financial planning, legal fees to set up wills and trusts, premiums for life insurance (a basic planning device), as well as estate administrative fees. (Of course, many of these services would still be needed even without the gift and estate tax, as financial planning is a good idea for any individual with substantial assets.) Indeed, one of the strongest arguments for junking the wealth transfer tax is that so many lawyers, financial planners, and insurance agents are its main beneficiaries, not the U.S. Treasury. For this same reason, those professionals who earn their livelihood off the current tax regime have been in the forefront of opposition to efforts to repeal the estate tax. It is ridiculous that the tax laws should encourage people to consume their life’s savings before they die, set up unwanted trusts, or give away their assets in $10,000 increments, just to avoid estate tax. Unfortunately, it is much too expensive not to do just that! Aside from these perfectly legal and proper methods of minimizing tax liability under the estate tax, there are also a host of much more aggressive and highly questionable practices that professionals employ to reduce the tax for clients. Almost all of these include gimmicks to reduce the value of assets in an estate, and hence the tax liability owed. These include claiming unwarranted discounts for stock ownership of a family business, as well as using family limited partnerships to justify lower valuations. The IRS faces a daunting task in administering the estate taxes, as it requires double-checking, and if necessary, challenging the values claimed for all major assets reported on all estate tax returns that are filed—to say nothing of all those gifts, which simply go unreported. With its limited resources, the capacity of the IRS to administer the wealth transfer tax regime is not likely to improve very much in the immediate future. Only a very significant increase in the budget of the IRS would have an impact on the agency’s ability to police the system that Congress has created. Even with President Bush’s $9.4 billion budget for the IRS in 2002 (a 9 percent increase over 2001), the agency faces insurmountable obstacles in administering the gift and estate tax.

Reforming the Estate Tax In the end, wealth taxation is just one of those fundamental public policies that divides liberals from conservatives, and generally, Democrats from Republicans. However, liberals were never more than halfhearted supporters of the wealth transfer tax regime. After all, it is hard to support a tax system that fails in its 153

GOP Campaign to Kill the “Death Tax” main objective (breaking up concentrations of wealth), imposes significant compliance costs even on taxpayers who will never actually be subject to the tax (but who still must pay professional advisers to achieve that end), is so easily evaded, and at best contributes minor revenue to the federal coffers. Still, for any Democrats to join Republican efforts to repeal the wealth transfer tax, there had to be some compromise that would avoid giving the wealthiest 1 percent of the population (and their heirs) a big tax cut. In fact, there was a compromise position. The goal of reformers should be to avoid allowing family fortunes to escape taxation altogether, but at the same time end the expensive, duplicative estate tax regime. The compromise position would accept repeal of the estate tax and at the same time support elimination of the unwarranted loophole in the income tax that forgives tax on capital gains at death. There is precedent for such a reform, as Australia recently repealed its wealth transfer tax and replaced it with a carryover basis rule that defers, rather than forgives the capital gain at death through a basis step-up. The Treasury Department estimates that the stepup in basis at death cost the Treasury $27 billion in 2000, and would cost some $153 billion for the five-year period from 2001 to 2005—so eliminating it would roughly compensate for repeal of the estate tax. Of course, eliminating the basis step-up was tried before, in 1976. At that time, powerful interests rallied and persuaded Congress to reinstate the basis step-up. In the current campaign, Republicans seemed to have recognized from the start that in order to get some Democratic votes in favor of repealing the estate tax, it would be necessary to modify or repeal the basis step-up. The ill-fated Death Tax Elimination Act of 2000 included a provision that would have eliminated the step-up in basis at death. That bill provided that once the wealth transfer tax was fully phased out by the year 2010, beneficiaries of transfers of assets of $1.3 million or more would take a “carryover” basis, rather than a stepped-up basis in such assets.38 This same approach was followed in the new regime established under the Economic Growth and Tax Relief Reconciliation Act of 2001, which provides that the basis step-up is repealed after December 31, 2009, the date that the phaseout of the estate tax, is complete. After this date, each estate is allowed to increase the basis of the assets it holds by $1.3 million. In addition, the basis of property left to a spouse can be increased by $3 million. What this means is that as of January 1, 2010, beneficiaries will inherit the income tax liability for the gain inherent in transferred assets beyond the $1.3 million and $3 million exemptions, rather than having that tax liability wiped out by a complete basis step-up at death. For individuals with great wealth, the new carryover basis regime will have a significant impact. For those with modest estates of $3 million or less, the new law will have little or no impact. Of course, it need not affect even the super-rich. If those who inherit great wealth then pass it on to their children, capital gains tax still will not be collected by the government. So this “reform” would not necessarily raise much revenue. Even worse, the plan

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GOP Campaign to Kill the “Death Tax” is an administrative nightmare for both taxpayers and the government. Because of the new carryover basis rule, beneficiaries will have to keep track of their donor’s tax basis in the inherited assets exceeding the exempt amount. Assuming that Dad can even compute his own tax basis in his property (e.g., the family business, heirlooms, or the family vacation home), it is highly unlikely that his heirs will ever know such figures. If the heirs ever sell any of these inherited assets, it will be difficult, if not impossible, to compute the gain recognized. It is this recordkeeping that makes the carryover basis regime adopted by the 107th Congress untenable. The alternative to giving beneficiaries a carryover basis for bequests and devises was to bite the bullet and tax at death any built-in gain inherent in the decedent’s assets. This would require that the decedent’s assets be valued at death (just as they must be under the current estate tax system), but instead of forgiving the capital gains inherent in his assets, his estate would owe income tax on any such gain. In tax parlance, death would be treated as a “realization event” under the income tax—just as a sale or exchange is under current law.39 (To prevent avoidance of this tax through inter vivos gifts, tax also would have to be triggered by transfers of appreciated property by gift.40) Beneficiaries would take their bequests net of the income tax paid by the estate, but without any record-keeping obligations or tax liabilities of their own. The current preference for long-term capital gains would still apply (20 percent), or a new graduated rate structure for capital gains tax recognized at death could be adopted. Larger estates could pay at the top marginal rate under the income tax, while lesser estates could be assessed at the 28 percent and 15 percent rates. On top of this, Congress could provide an exemption for small estates. This could be set at something in the order of the current $1 million exemption for the estate tax, or perhaps even higher. As law professor Lawrence Zelnick points out: “At some point, estates are small enough that the revenue gained from taxing their appreciation does not justify imposing the complexities of a capital gains tax (or, for that matter, of carryover basis).”41 Taxing inherent capital gains at death was proposed by the Kennedy administration back in 1963, and the Treasury Department reintroduced the idea again in 1969. The main objection to the proposal has always been that death should not be treated as a realization event, as is a sale or exchange. At death, there is no cash on hand to pay the income tax triggered, the way there is on the sale of an asset. Likewise, this is a problem where tax is triggered on an exchange, as there also is no cash on hand to pay the tax. This could present liquidity problems for estates with only a few major assets (such as a closely-held family business), and could require that some portion of the estate be sold off to pay the income tax due. Of course, this is also a problem under the estate tax—one that is usually solved by purchasing life insurance or borrowing against the assets to raise the cash to pay the tax. In general, critics tend to overstate the problems

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GOP Campaign to Kill the “Death Tax” associated with treating death as a realization event. They are really no worse than those imposed by the estate tax, which requires expensive appraisals for the assets of the estate. While the difficulties and costs of valuing large estates may be troublesome for purposes of determining any tax due on the capital gains deemed realized at death, they will be no different or greater than what is required under the current system or the carryover basis system adopted by the 107th Congress. The big advantage is that there would be only one tax system (the income tax) to plan for, comply with, and administer. Indeed, there would no longer be a justification for a second tax system (the wealth transfer tax), as accumulated wealth would be taxed under the income tax. To some, this system may seem harsh and punitive as it imposes income tax at death. However, this is precisely the system that our liberal neighbor to the north now employs. Canada recently repealed its national wealth transfer tax, and instead, imposes income tax on the decedent’s accrued capital gains. The inherent gain is treated as realized and taxable income to the decedent taxpayer. So far, the system seems to be working quite well, and thus offers a model that U.S. policymakers still have time to emulate. Before the basis carryover rule takes effect in 2010, Congress might be persuaded to adopt a regime that imposes income tax at death.42 Another alternative would be to include in income all gifts and bequests. These are currently exempt by statute from income tax.43 That way, transfers of wealth would still be taxed, but only under his income tax and at considerably lower rates. In fact, this was the system followed under the income tax of 1894, before the federal estate tax was enacted. The main advantage is that with only one tax regime (the income tax), all the substantial compliance costs associated with the wealth transfer tax would eliminated. As it is, the exclusion from income tax for gifts and bequests received by a taxpayer is inconsistent with a pure income tax. This exclusion could be repealed in conjunction with, and as the trade-off for, the repeal of the gift and estate taxes. Probably the simplest solution all along was to modify the current estate tax by raising exemptions, closing loopholes, lowering tax rates, and broadening the tax base. This approach has been endorsed by Joel Slemrod of the University of Michigan and William Gale of the Brookings Institution, two leading tax experts who suggest: “A higher exemption would help focus the tax on the ‘truly wealthy.’ Closing loopholes would help raise revenue lost by a higher exemption or a lower rate.”44 The result of such reform would be a wealth transfer tax that more closely resembles what was originally enacted in 1916. The tax would apply only to a very small number of very wealthy taxpayers, thereby avoiding the many disincentives and inefficiencies that result from the tax. It also would be a much easier tax for the IRS to administer and monitor. A number of moderate Republicans and Democrats on the Senate Finance Committee seemed to favor this approach, but they did not have enough votes to block those on the committee who pushed for repeal, such as Chairman Charles Grassley and Don Nickles, 156

GOP Campaign to Kill the “Death Tax” chairman of the IRS Oversight Subcommittee. Basically, the 107th Congress introduced a new “reformed” estate tax regime for the next ten years, with lower rates and a much higher exemption, followed by complete repeal of the whole estate tax regime in 2010. Most liberals opposed this Republican plan to repeal the current estate tax purely on principle. State governments, which benefit from a credit allowed against federal estate tax for state death taxes paid by a decedent, also opposed repeal as it undoubtedly will cost them significant revenue as well. At the same time, the army of professionals who make their living off the estate tax have been in the forefront of the opposition based on self-interest. Sadly, this includes representatives of the thousands of universities, charities, and churches, which benefit from the estate tax to the extent that it encourages the wealthy to give them tax-exempt gifts and bequests to reduce their tax liability. The possibility that repealing the estate tax would reduce the volume of bequests to these tax-exempt charities is used by some as an argument for retaining the estate tax. This pernicious argument assumes that it is necessary for the government to impose a significant tax on estates in order to create economic incentives for charitable giving. Of course, by allowing a deduction for charitable bequests, the government is only giving the decedent the option of deciding how much of the taxable portion of his estate that will not pass to heirs should go to the U.S. Treasury and how much to favorite charities. Without the 55 percent tax (or even the 45 percent tax that will apply in future years), the individual would be free to decide how much, if any, of his entire estate should go to heirs and how much to charities. In any event, some experts argue that the impulse for charitable giving is not so dependent upon tax incentives as many assume.45 Others have found that potential donors are responsive to powerful economic incentives such as a tax deduction for contributions or bequests.46 Nevertheless, that in itself hardly constitutes a reason for imposing such a high transfer tax. Arguing that we ought to impose a high tax to force the wealthy to be charitable is a fancy way of saying that the rest of us would like to enjoy the benefits that would flow from the wealthy giving their money to public charities, rather than leaving all their life savings to their heirs. Sure, we are better off, but that alone does not create a right of the majority to seize the property of the few. There needs to be some better justification. Along with the powerful and ideologically motivated Republican opposition to the entrenched wealth transfer tax regime, there always have been compelling and rational reasons for trying a new approach. The gift and estate tax is difficult to administer, raises minimal revenue, and imposes excessive and unnecessary compliance costs on those caught within its grasp. Despite these acknowledged shortcomings, only a handful of Democrats supported the Republican-led campaign to repeal the estate tax. Likewise, few Democrats supported efforts to reform the old wealth transfer tax regime. Now that Republicans have enacted their 10-year phaseout of the estate tax, Democrats must decide upon a more 157

GOP Campaign to Kill the “Death Tax” accommodating response and propose an alternative to outright repeal. Perhaps if the political fortune of the GOP declines after the 2002 midterm elections, Democrats will mount their own political campaign to reintroduce some modified version of an estate tax. Of course, because those provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, which repealed the federal estate tax, will expire on December 31, 2010, the estate and generation-skipping taxes along with the old basis step-up rule will return on January 1, 2011, unless Congress takes further action. Undoubtedly, Republicans will attempt to make the new regime permanent, but that will require considerable revenue from other sources. With more modest budget surpluses now projected, it will be very hard for a GOP campaign to permanently repeal the estate tax to succeed. Most likely, a future Congress (especially one that is controlled by the Democrats, rather than the antitax faction of the GOP) will opt for “reform” of the estate tax, rather than just a disguised tax cut for the super-rich. If that is the case, expect that some time before 2010 the estate tax will be resurrected with very high exemptions levels that render the tax applicable to only a small number of very wealthy individuals. Despite the current GOP victory in phasing out the estate tax, that is the most likely scenario in the long run. Ultimately, revenue considerations and the dynamics of an evenly divided Congress dictate strongly in favor of such a compromise outcome. However Congress ultimately decides to deal with the estate tax, whether complete repeal is made permanent or a new reduced version of the tax returns in 2011, Republicans had a major victory in 2001 in their war against the wealth transfer tax regime. As Calvin Trillin put it in a poem written specially for the occasion: “For years, estates of wealthy men were taxed—The sort of thing that spoils a nice goodbye. The tax will disappear by 2010. And then the rich will find it safe to die.”47

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The Great Corporate Tax Giveaway Abusive tax shelters are the most serious compliance problem in the U.S. tax system. —Treasury Secretary Lawrence H. Summers (2001) A deal done by very smart people that, absent tax considerations, would be very stupid. —Prof. Michael J. Graetz of Yale Law School, defining a tax shelter

According to the conventional wisdom, Congress shut down the tax shelter industry back in 1986. Until then, wealthy taxpayers could find all sorts of dodges to avoid paying taxes on their income. Rich dentists, doctors, lawyers (anyone with significant income) could buy investments that would generate artificial tax losses to shelter their income and thereby reduce their taxes. Even if offsetting income was recognized in later years, the benefit of tax losses up front would create a substantial economic savings. Under tax law at the time, this was all perfectly legitimate. But tax shelter promoters got more and more greedy in the late 1970s and early 1980s, and the deals turned aggressive and ugly, with outright shams becoming commonplace. Syndications were put together to sell off artificial tax losses generated by partnerships owning office buildings, books, railroad boxcars, porno films, and even cemeteries. The IRS was caught up in a nearly futile effort to police these phony deals, and the docket of the U.S. Tax Court was swamped with litigation involving tax shelter cases. Finally, Congress struck back with the Tax Reform Act of 1986, which effectively closed down the tax shelter industry. Under the so-called Passive Activity Loss Rules (or PALs, as they are affectionately know to tax professionals), the deduction for losses generated by these investments is deferred, thereby wiping out any tax benefit.1 That was the end of that—or so everyone thought. The New Corporate Tax Shelters In the 1990s, the tax shelter industry came back with a vengeance! Only this time, it is the Big Five accounting firms and Wall Street investment bankers who are 159

The Great Corporate Tax Giveaway leading the assault on the U.S. Treasury. Marketing tax shelters is big business again. This time, rather than selling to wealthy individual investors, promoters are peddling their new “products” to some of the largest, most profitable corporations in the United States. In deals that would have made tax lawyers blush just a few years ago, tax shelter promoters are creating tax losses out of thin air for their corporate clients. This includes Enron, once the seventh largest corporation in the United States, which not only managed to avoid paying corporate income tax in four of the five years prior to its recent collapse, but even qualified for $382 million in tax refunds. This was accomplished through the use of nearly 900 corporate subsidiaries located in off-shore tax havens. What is driving the recent surge in corporate tax shelters? The answer is simple: Money. Corporations save millions in taxes, and the accounting firms and investment bankers who put these deals together make millions in fees. In recent years, the Treasury Department, Congress, and the federal courts have wrestled with a tax shelter industry wrecking havoc on the tax code. Every time one tax shelter is shut down, promoters dream up another to replace it. In the meantime, the corporations that buy into these schemes are cutting their tax bills and promoters are lining their pockets—all at the expense of the rest of us taxpayers. The new tax shelters go by various names. One recently under attack by the IRS goes by its acronym: BOSS (or “Bond and Option Sales Strategy”). This deal was peddled by the accounting firm giant, PricewaterhouseCoopers. The scheme is complicated and relies on use (or abuse) of some highly technical tax rules. Customers join in a general partnership that in turn forms a limited liability company in the Cayman Islands with an investment fund affiliated with the promoter, PricewaterhouseCoopers. The partnership and the investment fund borrow several hundred million dollars from an accommodation lender and then contribute the proceeds to the limited liability company, which uses the borrowed cash to purchase certificates of deposit. The entire investment is hedged, so there is really no risk to the limited liability company, the lender, or the investors. In fact, there never is any risk of economic loss or a bona fide business purpose for this kind of deal—just meaningless transfers of funds to take advantage of the tax code and camouflage what’s really going on. In the case of the BOSS deal, when the limited liability company ultimately liquidates and distributes the CDs to the investor/partners, a short-term capital loss is claimed. That’s good for the corporate investors because there really is no economic loss suffered—only a tax loss. In a public notice issued in December 1999 specifically to shut down the BOSS deal, Treasury held that the capital loss is artificial and may not be deducted: “Through a series of contrived steps, taxpayers claim losses for capital outlays that have in fact been recovered.”2 In a rare display of fortitude, Treasury also threatened civil penalties for those who would claim the artificial losses purportedly derived from investing in the BOSS tax shelter. But even as a tax shelter such as the BOSS deal is shut down, another is cooked up in the offices of 160

The Great Corporate Tax Giveaway some accounting firm or investment banker to take its place. In fact, reports soon aired of a “son of BOSS” transaction even more egregious than the original. The resurrected BOSS shelter uses a trust to camouflage the transaction from IRS auditors. University of Texas law professor Calvin Johnson has stated that the new BOSS deal smacks of “willful misrepresentation of the law.”3 Apparently the Treasury Department agrees—in a public notice issued in August 2000, it threatened criminal fraud charges against anyone promoting the deal.4 Each corporate tax shelter is a bit different, but all share common themes. Usually, a technical tax rule (often intended by Congress or the IRS to prevent some other abuse of the tax laws) is exploited to create artificial tax losses in ways that were never imagined by the tax authorities. The new tax shelters do not exploit some “loophole” in the tax law, but rather rely on an unforeseen and unintended application of a rule designed for some entirely different purpose. Typically, a foreign “investor” is brought into the deal to pick up the offsetting income recognized on the deal. The foreign investor (usually an entity created under the laws of some tax haven, such as the Cayman Islands or the Netherlands Antilles) is not subject to U.S. taxation, and is allocated all of the taxable income, while the U.S. corporate investors are allocated the artificial tax losses. Very convenient! Wall Street investment bankers provide the financial products (socalled derivatives) that hedge the “investment” for all parties, so that no one is really at risk of losing one penny. If this were allowed, the result would be a massive erosion of the corporate income tax—at least for those corporations willing and capable of paying the enormous fees demanded by tax shelter promoters and investment bankers for putting together these schemes.

The Government’s Response To date, Congress and the IRS have tackled the new tax shelters on a case-by-case basis. In fact, the IRS has had considerable success in litigating against individual shelter deals. The federal courts have been favorably inclined toward IRS challenges, which invoke well-established principles holding that tax deductions produced by “sham” transactions are disallowed and tax-motivated transactions lacking a “business purpose” or “economic substance” shall be disregarded. In a leading 1998 case, ACM Partnership v. Commissioner,5 an abusive tax shelter marketed by the giant investment house Merrill Lynch & Co. to ColgatePalmolive Co. was slammed by the Third Circuit Court of Appeals, thereby providing strong precedent for the IRS in subsequent cases. That shelter was designed to take advantage of a regulation involving the installment sales method of reporting taxable gain. Merrill Lynch managed to generate a $98.5 million capital loss for Colgate, so the victory for the IRS netted a cool $30 million of tax. But a case such as this represents only one taxpayer in one tax shelter deal. Promoters market the same scheme to numerous clients. There are at least eight 161

The Great Corporate Tax Giveaway cases similar to ACM still in dispute, with as much as $1 billion in additional tax at stake. So the IRS’s resounding victory in ACM will likely encourage those other corporations to settle quickly with the IRS on a basis favorable to the government.6 The IRS had even greater success in 1999. In a string of cases decided by the U.S. Tax Court, the IRS won impressive victories over corporate taxpayers who invested in tax shelters. In Compaq Computer Corp. v. Commissioner,7 the IRS successfully challenged the giant computer manufacturer over a $3.38 million tax savings created by churning investments in order to utilize lucrative foreign tax credits. (However, the victory was short-lived as the Tax Court’s decision was ultimately reversed by the U.S. Court of Appeals for the Fifth Circuit.8) In another important case decided by the Tax Court, Winn-Dixie Stores, Inc. v. Commissioner,9 the IRS took in $1.6 million by challenging a $3.7 million deduction for interest paid on loans from cash value life insurance policies taken out by Winn-Dixie on the lives of over 36,000 employees (some of whom no longer even worked for the company). Already this year, the IRS scored several comparable victories, most notably a case against American Electric Power in the U.S. District Court in Ohio.10 As there are over 100 other cases still in dispute involving similar leveraged corporate-owned life insurance (COLI) tax shelters, nearly $6 billion of tax revenue is at stake with respect to this scheme alone—and that may be just the tip of the iceberg, as many other cases of COLI tax shelters surely will be uncovered in future audits! Of course, many similar tax shelter cases will not be uncovered. In testimony before the House Ways and Means Committee in November 1999, Lindy Paull, Chief of Staff of the Joint Committee on Taxation (the congressional agency that provides Congress with professional advice on tax issues), warned that it is beyond the capacity of the government to police all the corporations that are claiming tax benefits from tax shelter investing. “In many cases, the corporation that claims the tax benefit from a tax shelter escapes audit, or the tax shelter arrangement goes undetected during an audit.”11 Even when detected, the IRS does not have the manpower to litigate all these case in the courts.12 That is thanks to budget cuts inflicted by recent Republican-controlled Congresses on the tax agency! Because of the shortage of funds and manpower, the IRS often agrees to a settlement favorable to the taxpayer—or at least, one that does not penalize the taxpayer for trying to claim the sham deductions. So by taking questionable deductions and then playing the audit lottery, corporations stand to save millions in taxes—even if they are caught by the IRS! In another 1999 case, Saba Partnership v. Commissioner,13 Senior Judge Arthur L. Nims III of the U.S. Tax Court held against Brunswick Corp., an investor in yet another Merrill Lynch deal similarly designed to generate capital loses through the manipulation of the aforementioned IRS regulations governing installment sales. More important than winning on the tax issues, the IRS scored

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The Great Corporate Tax Giveaway a victory in Saba when Judge Nims affirmed that advice provided by tax counsel for a tax shelter deal is not privileged—thereby denying promoters the shroud of secrecy afforded to privileged communications. Without that protection, promoters and their legal counsel can be held accountable for the more egregious abuses uncovered by the IRS. The government is not just waging the fight against tax shelters in the federal courts. In early 2000, the IRS established a new office to coordinate its activities in auditing corporate taxpayers and combating illegal schemes. Congress enacted legislation last year to prevent tax benefits from “basis-shifting” realized on the transfer of assets subject to liabilities in corporate reorganizations. Likewise, the infamous “lease in, lease out” (or LILO) transaction was shut down in March 1999 by the Treasury Department through a public notice.14 That scheme involved U.S. corporations entering into “leases” for property owned by foreign municipalities. Deals were put together for all sorts of European properties, such as a highly publicized attempt to lease city office buildings (valued at $149 million) in Bern, Switzerland, to a U.S. corporate taxpayer. Leasing the property back to its foreign owner (the owner and user of the property) can create big up-front deductions for the taxpayer, thereby reducing its U.S. tax burden, while the offsetting income is generated by the foreign municipal government, which is conveniently beyond the reach of U.S. tax authorities. Clever arrangement, and it worked—at least until the Treasury Department stepped in. The problem with a case-by-case attack on tax shelters is that the promoters are always one step ahead of the government. As the promoters market their various products to more and more clients, eventually the IRS and Congress get wind of what is going on. Professional tax journals report on the latest schemes virtually every week. Occasionally, a story about a particularly ingenious tax gimmick even lands on the front page of the Wall Street Journal or New York Times. While such exposure is certainly the kiss of death for that particular deal, it does not really matter to promoters. They know that there is a limited shelf-life for all their deals. Even if the IRS does not step in, once competitors and corporate managers learn the specifics of a particular arrangement, no corporation is willing to pay big fees again for that tax-savings investment. The promoter’s fees are justifiable only so long as the scheme is confidential and marketed to a limited number of corporate clients who all agree to keep their mouths shut. As soon as word gets out on the street about an existing shelter, promoters necessarily must abandon it and cook up another scheme. Media publicity and an IRS challenge simply hasten the process. Even if Congress responds with legislation or the Treasury Department with a public notice, and a particular variety of tax shelter is outlawed, it is almost always on a prospective basis—thereby implicitly sanctioning those deals in place before the effective date of the new legislation or regulations. The irony is that vigilance against existing tax shelters (which by the time they are known, usually are no longer even being marketed) just encourages

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The Great Corporate Tax Giveaway the promoters to dream up new schemes even faster. As one close observer of corporate tax shelters has wryly suggested: “By legislating the obsolescence of existing tax shelters, Congress creates a market for new shelters.”15 If a case-by-case approach has its limits, the alternative may not be much better. In the 106th Congress, House Ways and Means Committee member Lloyd Doggett (D-Tx.) introduced legislation, the “Abusive Tax Shelter ShutDown Act” (H.R. 2255), that would have granted the IRS expansive authority to disallow deductions generated by tax shelters. He has also proposed similar legislation in the 107th Congress, with the ranking Democrat on Ways and Means, Charles Rangel, signing on as a co-sponsor. The problem is that no one can readily define a tax shelter (or “noneconomic tax attributes,” in the parlance of Doggett’s bill), and thus the power granted to the IRS necessarily must be broad, vague, and discretionary. No surprise that the IRS and Treasury Department support this approach. Some academics also support such a legislative fix.16 At hearings before Ways and Means, Treasury officials denounced the current “ad hoc and piecemeal approach” as inefficient and too costly. Instead, Treasury wants Congress to adopt a “global legislative solution” to “prevent abusive, taxengineered transactions before they occur.”17 Others urge a more cautious approach—one that would not give Treasury vast powers that could be used to attack perfectly legitimate business transactions. The influential Tax Section of the American Bar Association and the American Institute of Certified Public Accountants both have supported new regulations imposing increased penalties and disclosure requirements for tax shelter investors. So has the Joint Committee on Taxation. That was exactly how the Clinton administration approached the problem. Lawrence Summers, treasury secretary during the second Clinton administration, called the growth of corporate tax shelters “a matter of national importance” and “the most serious compliance problem in the U.S. tax system.”18 To deal with the problem, Summers proposed new disclosure requirements for corporations that claim substantial tax savings in transactions designed by outside promoters. These Treasury regulations impose disclosure requirements, as well as registration requirements on those who promote “confidential” tax shelter deals to their clients.19 The IRS recently announced that promoters have already registered over 2,500 such tax shelters marketed under terms of confidentiality.20 According to the manager of the IRS Office of Tax Shelter Analysis (OTSA), more than 19 letters were sent to promoters in January 2001, each requesting follow-up information regarding promotional materials and investor lists.21 The government considers promoters the “root of the problem,” and these kinds of document requests allow the IRS to monitor their activities. In the waning days of the Clinton administration, additional regulations were proposed imposing new professional standards on attorneys who issue so-called opinion letters that are used by promoters to help sell deals to investors.22 The proposed regulations would define a tax shelter as a transaction with a “significant purpose of federal tax avoidance.” 164

The Great Corporate Tax Giveaway The jury is still out on whether these kinds of regulations will do very much, especially because enforcement by the administration of George W. Bush is less than enthusiastic. In the past, penalties and disclosure requirements have not worked very well to curb other tax abuses. Prior reforms enacted in the 1990s requiring the registration of tax shelters were ineffective in deterring promoters. IRS officials admit that the registration materials submitted are just collecting dust, with the tax agency unsure what to even do with the massive volume of information! Likewise, relying on increased penalties to deter overly aggressive tax shelter promoters requires more frequent IRS audits of corporate tax returns.23 With budget cuts and Republican legislation intended to rein in the IRS (such as the Internal Revenue Service Restructuring and Reform Act of 1998), increased scrutiny of corporate tax returns by the IRS is impossible. On the other hand, in the first full year under the new disclosure requirements, some 50 companies filed disclosure statements for tax shelter investments totaling $4 billion. Of these, the IRS determined that some 25 companies had “evaded” taxes through their shelter investments.24 One company alone reduced its tax liability by $500 million in tax year 2000. Of course, the companies may choose to fight any IRS challenge to their deductions, so there is no guarantee that the government will recoup the full $4 billion. Still, at least it knows about their aggressive claims for tax deductions. That is a start. In December 2001, the Treasury tried a new “carrot and stick” approach, offering to waive penalities for those corporations that voluntarily disclose their past shelter activity. To date, there have been few takers, with only about 150 disclosures made in the first four months of the amnesty program. Most tax advisers think that the government is offering too little “carrot” to compensate for the huge potential tax liabilities at stake. Some argue that the recent success of the IRS in litigating against abusive tax shelters means that there is no need for any further legislative initiatives. Ken Kies, the former Chief of Staff of the Joint Committee on Taxation (from January 1995 until February 1998, during which time he reported to the Republican chairmen of the Senate Finance and House Ways and Means Committees) who left government to head PricewaterhouseCoopers’s tax lobbying group (since acquired by an Illinois consulting firm), has been leading the lobbying against new antishelter legislation. Appearing at hearings before the House Ways and Means Committee, as well as countless meetings of bar and accounting associations around the country, Kies defiantly declares that no new legislation is needed because the IRS is already winning the battle against tax shelters—which incidentally, he does not think cost the Treasury very much in lost revenue. Pointing to the steady increase in revenue collected under the corporate income tax during the 1990s, Kies scoffs at claims that the new tax shelters are costing the government significant revenue. But this hardly proves the point. The increased revenue from the corporate income tax that flowed in the Treasury during the mid- and late 1990s was mostly the product of the booming economy, and who 165

The Great Corporate Tax Giveaway knows how much higher the revenue would have been but not for the shelters. You can bet that all those corporations are not paying his accounting firm million-dollar fees just to pay the same amount of tax that they would have owed without their tax shelter schemes! While testifying in November 1999 before Ways and Means Committee hearings, Kies was confronted by Rep. Doggett with a copy of an early draft of the BOSS tax shelter that his own firm was marketing. In prior testimony that spring, Kies had denied that his firm was involved in marketing “tax-avoidance schemes.” He now claimed that he was unaware that his firm was connected with the BOSS deal. According to a story in the Wall Street Journal, an anonymous tipster (most likely someone in PricewaterhouseCoopers who still has a conscience and some professional ethics left) mailed the draft for the BOSS deal to Treasury, which passed it on to Doggett.25 Even if Kies really knew nothing about his own firm’s marketing of the BOSS deal, that actually may be an indication of something worse than mere dishonesty. After all, the tax and audit departments of PricewaterhouseCoopers are supposed to perform a public function in certifying the financial statements and preparing the tax returns of their clients. When partners in the same accounting firm are putting the client into fraudulent tax shelters such as the BOSS deal, the ability of the public and investment community to rely on the judgment of the auditing and tax departments of the same accounting firm is severely compromised. While President Clinton pushed hard during the last two years of his administration to combat the tax shelter promoters, it was clear from the first that things would be different in Washington under the new Bush administration. The problem of corporate tax shelters was virtually ignored by the candidates in the 2000 presidential campaign. Only Bill Bradley, one of the architects of the Tax Reform Act of 1986, which shut down the old tax shelter industry, raised the issue during the Democratic primaries. When Bradley left the race, the topic disappeared altogether. Vice President Gore, who supported efforts by the Clinton administration to regulate shelter activity, never raised the issue in his campaign. Certainly, George W. Bush is not likely to support reforms to rein in the tax shelters that save millions in taxes for the well-heeled corporate PACs that supported his presidential campaign. Furthermore, Bush’s nominees for key positions in the Treasury Department were less than enthusiastic supporters of efforts to regulate the shelter industry. For example, Bush’s nominee for Chief Counsel of the IRS previously represented (successfully) major corporations in tax shelter cases litigated by the Service.26 Likewise, Bush’s first Treasury Assistant Secretary for Tax Policy, Mark Weinberger, previously worked in the national tax office of the accounting firm giant, Ernst & Young. Prior to that, he owned and ran his own lobbying firm, Washington Counsel PC, which represented large corporations in tax matters. In the past, Weinberger sided with Ken Kies, discounting the significance of corporate tax shelters in reducing the corporate tax base. After his nomination was confirmed by the Senate, Weinberger 166

The Great Corporate Tax Giveaway immediately testified before the Senate Finance Committee in an effort to reassure its members that he would continue efforts by the Clinton administration to combat taxpayer fraud and overly aggressive corporate tax shelter promoters. At the hearings and in subsequent interviews, Weinberger specifically mentioned the new disclosure regulations issued by the prior administration as a worthy first step in curbing abusive tax shelters.27 In March 2002, Weinberger outlined the Treasury’s new plans with respect to curbing abusive tax shelters—and then abruptly announced his resignation after less than a year in office. As expected, he returned to the private sector where he can best capitalize on his government connections. He may even join lobbying efforts seeking to overturn the antishelter regulations by the Clinton administration, proposed but yet to be finalized. On Capitol Hill, the Republican congressional leadership has consistently downplayed the whole issue. In the 106th Congress, Bill Archer of the Ways and Means Committee used to brag that his committee had stopped the “avalanche of bad proposals” to regulate corporate tax shelters introduced by the Clinton administration. Bill Roth was about the only senior Republican in a position of power who admitted there even was a problem—and he is gone from the Senate. To date, a hands-off attitude has prevailed among Republicans in the 107th Congress. House Majority Leader Dick Armey still scoffs at the notion that corporations are doing anything wrong. Armey, who holds a Ph.D. in economics, recently declared: “The business of a corporation is . . . to maximize its earnings for its shareholders. Since tax is a very large part of their costs, anything they can do to minimize that share of their costs would be a legitimate thing. Obviously, they need to do what is legal, and we presume they are doing that.”28 That is a mighty big presumption—one contradicted by all the recent court cases.

Cost of Corporate Tax Shelters While it is impossible to determine with certainty how much the new corporate tax shelters are actually costing the U.S. Treasury, most experts believe that the revenue loss is significant. Back in 1999, Professor Joseph Bankman of Stanford Law School threw out a figure of $10 billion a year. Journalists and Treasury officials repeatedly cited that number for years, but Bankman later admitted that it was just an off-hand estimate. Nevertheless, Bankman’s off-the-cuff estimate of $10 billion a year is now widely cited as if it were an authoritative figure. The truth is, no one really knows for sure how much the new breed of aggressive corporate tax shelters are costing the government. One serious attempt to appraise the revenue loss from the new corporate tax shelters comes from economist Martin Sullivan, who concludes that the annual cost is somewhere between $3 billion and $30 billion.29 Sullivan is quick to admit that his own estimate is based on many debatable assumptions about the 167

The Great Corporate Tax Giveaway magnitude of the fees earned by promoters and the associated tax benefits realized by their clients. Obviously, there is no objective way to measure the extent of tax shelter activity. Still, recent data from the Treasury Department supports claims of a surge in corporate tax shelter activity.30 The report shows that over the past three years, the annual rate of growth of corporate tax refunds has been more than 20 percent—this despite surging corporate profits. For the period from 1985 to 1996, refunds ranged from $13 billion to $19 billion. In 1997 and 1998, refunds hit $22 billion and $25 billion, respectively. Refunds set a record of over $31 billion for 1999, and when the numbers are in for 2000, they will likely exceed $30 billion.31 While no one knows for sure what is behind this increase in corporate refunds, the prime candidate is increased tax shelter activity. Extensive use of stock options as executive compensation (deductible for tax purposes, but merely “disclosed” for financial accounting) has also certainly played a major role in keeping corporate tax obligations down while profits soared. In the end, no one really knows the extent of the damage inflicted on the U.S. Treasury by the new breed of corporate tax shelter promoters. Whether the IRS will win the battle is anyone’s guess. They probably should not count on much assistance from the Bush administration or the Republican controlled 107th Congress. Furthermore, no one should underestimate the ingenuity and audacity of the promoters, accountants, and investment bankers. Even in the unlikely event that the federal government makes a concerted effort to clamp down on their current questionable practices, they are sure to move into new territory and devise new strategies for gaming the system. Ironically, the major factor lending itself in favor of an effort by Congress to rein in corporate tax shelters is that the revenue raised by such legislation (presumably, as much as $10 billion a year) could be used in an omnibus revenue package to finance another round of tax cuts sponsored by the Bush administration. As discussed below, such revenue raisers now play an extremely important role in the legislative and budget processes in Congress. Absent that, there really does not seem to be much interest in Washington in clamping down on the new tax shelter industry.

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8

The Politics of the Surplus [T]he great question before Congress is what to do with the surplus. —Economist Henry George (1883) In truth, the challenge before this committee—indeed the challenge before the new administration and this new Congress—of reaching balance in a world of surpluses may be more difficult than it was in a world of deficits. —Senate Budget Committee Chairman Pete V. Domenici of New Mexico (2001) Budgets aren’t about numbers. For presidents, budgets are about their game plan. It’s a way to define themselves. —House Budget Committee Chairman John Kasich of Ohio (2001)

In late 1996, predictions of imminent budget surpluses began circulating in Washington. After decades of deficits, a soaring national debt, and projections of budget shortfalls for years to come, suddenly the government’s economic position was turning around. Mostly, this was attributable to the economic prosperity that the nation had been enjoying since late 1992. The unprecedented, sustained economic growth of the mid-1990s was resulting in record receipts under the federal income tax. Revenue literally began pouring into the U.S. Treasury faster than the government could spent it—at least, for the time being. For 1996, adjusted gross income reported on individual tax returns rose 8.3 percent over the prior year, and total individual income taxes rose 12 percent. Most of this increase was attributable to a surge in realized net capital gains—up 48 percent over 1995. These trends picked up steam in 1997 and continued for the rest of the decade. For fiscal year 1998, the income tax (corporate and individual combined) raised over $1 trillion for the first time ever, and total federal receipts topped $1.72 trillion.1 By fiscal year 2001, the individual income tax alone would raise over $1 trillion. After decades of budget deficits and a soaring national debt, the Age of Surplus had finally arrived! Just as decades of deficits previously affected contemporary tax policymaking, so forecasts of unending budget surpluses affected policymaking for the 169

The Politics of the Surplus federal income tax. Similarly, the arrival of surpluses had an immediate impact on the budgeting process, as well as the most important domestic policy program—Social Security. Indeed, it is fair to say that the impact of surpluses upon policymaking for the budget and the income tax was one of the most important stories to emerge in American domestic politics in the 1990s.

The Surplus Arrives Largely because of the surge in income tax revenue (as opposed to any great success in reducing expenditures on the part of the Republican-controlled Congress or the Democratic Clinton administration), the federal government ran a budget surplus in fiscal year 1998 for the first time in almost 30 years. And things kept improving after that. The Congressional Budget Office, the agency created by Congress in 1974 to provide legislators with independent nonpartisan economic forecasts and budget evaluation, was continually forced to revise upward its estimates of future surpluses. Even better, actual budget surpluses repeatedly exceeded CBO’s projections. For example, CBO initially predicted that the surplus for fiscal year 1999 would be $107 billion. It turned out to be $124 billion. Even more amazing, CBO estimated in January 1999 that over the next ten years, accumulated budget surpluses would total $2.6 trillion.2 Of course, $2.6 trillion dollars does not go as far as it used to, but this was more than enough to raise eyebrows in Washington. Indeed, it would prove enough for the Republican Congress to finance a few new pork-barrel tax expenditures and begin the next chapter in their campaign to refinance the American state. A trillion dollar surplus goes a long way toward justifying a major tax cut! As the economic boom entered its eighth straight year, CBO’s projections of budget surpluses continued to prove overly conservative. Amazingly, the economic forecasters were still underestimating future revenue flows. For example, CBO revised its budget estimates in January 2000 and concluded that the surplus for that fiscal year would reach $176 billion. In fact, it turned out to be $236 billion. Of this amount, $150 billion would be generated by Social Security (the “off-budget” surplus), but most important, $86 billion would come from governmental operations (the “on-budget” surplus). The on-budget surplus excludes annual surplus revenue from Social Security, as well as the much less significant revenue from a host of government-owned entities such as the U.S. Postal Service (which is included in gross revenue in the budget on a net basis). Conversely, the unified (or consolidated) budget includes surplus revenue from Social Security, the highway trust fund, as well as all of the 160 or so minor trust funds established and owned by the federal government. By popular convention, the excess of revenue over expenditures under the unified budget is what is typically referred to as “the surplus”—meaning that the Social Security surplus is included to boost the figure. By January 2001, CBO was predicting a $281 billion 170

The Politics of the Surplus surplus from the unified budget for fiscal year 2001 (already half over), and a whopping $5.6 trillion surplus for the 10-year period from 2001 to 2011.3 Of that amount, some $2.5 trillion would come from Social Security. That still meant that there would be a very hefty $3.1 trillion on-budget surplus—enough to retire virtually the entire national debt held by the public. Of course, there always are major qualifications to CBO’s economic forecasts. Like any economic forecast, the January 2001 report made certain assumptions about the future course of politics and the economy. For example, forecasts typically assume the “absence of significant legislative changes.” In other words, the analysis is based on the assumption that there will be no new tax cuts or new spending programs enacted during the relevant 10-year period. In fact, the 2001 10-year baseline assumed that discretionary spending would decrease to just 5.1 percent of GDP—a 20 percent reduction relative to the economy and a 10 percent reduction in per capita spending by the government.4 You can bet the house that Congress cannot reduce future spending to such austere levels. As if to prove the point, on the very day before George W. Bush signed his $1.35 trillion tax cut into law in May 2001, the Republican-controlled House Appropriations Committee added hundreds of millions of dollars to the President’s budget for fiscal year 2002.5 The CBO report also made important assumptions about future economic performance that may or may not come true. In this case, it was assumed that the economy would grow at the rate of 2.4 percent for the balance of calendar year 2001 (even though economic growth was virtually zero during the month of January 2001 when the report was issued, and had been only 1 percent for the final three months of 2000), 3.4 percent in 2002, and an average of 3 percent over the following eight years. This estimate of long-term growth was 0.3 percentage points higher than what had been assumed just six months earlier in CBO’s August 2000 midyear report, although it was considerably more conservative than the 5.1 percent growth actually experienced in calendar year 2000 or what Wall Street forecasters were then predicting for 2001. The CBO forecasters were also anticipating that Alan Greenspan and the Federal Reserve Board would lower interest rates even further in response to the economic slowdown that began late in 2000. Despite these assumptions, the CBO forecasters were not exactly predicting that the economy would grow by 3 percent per year, or that there will be no tax cuts during the period from 2001 to 2011, or that government spending would not exceed 5.1 percent of GDP. Nor were they really trying to divine the future behavior of Alan Greenspan or the Fed. Rather, the CBO economic forecasters simply made assumptions about future economic performance, government revenues, and government spending. These are just their best estimates of some very uncertain variables. Of course, other agencies, such as the Office of Management and Budget (OMB) or the Treasury Department, may make different assumptions, and hence reach different conclusions about the magni171

The Politics of the Surplus tude of future surpluses or deficits. Such differences are inherent in the nature of economic forecasting. But beware! Even small differences can really matter. For example, if the economic forecasters make assumptions that turn out to be even slightly inaccurate (e.g., because the economy does not grow as much as expected, or inflation picks up, or discretionary spending exceeds the assumed levels), then actual surpluses (or deficits) will diverge significantly from what was predicted. This does not mean the model or analysis was faulty, only that the assumptions relied upon were not entirely accurate.6 And if they are not entirely accurate, there can be very great differences between the projections and the actual results. This is true for one-year projections, and the differences are greatly magnified over longer periods of time. This is why 10-year projections can be so far off. Revenue collected under the income tax is particularly sensitive to economic growth, while projections of future spending are highly dependent upon interest rates. Accordingly, estimates of future surpluses must take into account not only how the next five Congresses will behave, but also how the economy will perform and how much tax revenue will be collected over the next 10 years. Of course, tax policy experts generally expect Congress to continue to renew (effectively making them permanent) the collection of business tax credits that expire every year or so. Businesses have come to rely on the tax credit for research and development expenses, and it would be almost impossible for Congress not to renew these tax preferences. At the same time, everyone recognizes that the alternative minimum tax (AMT) eventually must be permanently “fixed” as it applies to middle-income taxpayers. Estimates are that these two highly anticipated (but not yet legislated) reforms will cost the Treasury some $200 billion in tax revenue over 10 years.7 Other necessary fixes to the tax code will also cost the Treasury significant revenue and cut into projected surpluses. The uncertainty in predicting the future is the source of the great discrepancies between budget projections (which are always prospective) and the actual surplus or deficit (which is always determined after the fact). If the economy performs at a rate that is only a mere 0.1 percentage points higher than the growth rate assumed by CBO in its economic model, the result will be some $250 billion in extra revenue for the government. That extra $250 billion can be critical to the White House and Congress when putting together the next budget. Hence, it should come as no surprise that there is considerable pressure exerted on the economists who prepare CBO’s economic reports to make favorable economic assumptions that will result in higher predicted surpluses. In the budget process, the greater the 10-year surplus, the more policy options open to the politicians. In this way, the forecasts of obscure economists in an obscure government agency play an enormously important role in affecting those policymakers who actually set budget priorities.8 Ironically, the prospect of future surpluses can actually make the job of policymakers more difficult than it was back in the days of unrelenting budget deficits, when there were fewer options open, and hence little to fight over. With 172

The Politics of the Surplus trillion dollar surpluses predicted, those who put together the budget are subject to intense lobbying and political pressure from other congressmen, as well as the President, seeking increased funding for all their favored programs and policies. As odd as it may sound, it can be harder to “budget” (which implies making choices and prioritizing competing claims for resources) in the Age of Surplus than during a period of sustained deficits, such as that experienced in the late 1980s and early 1990s. It is harder to resist demands for funds in the face of predictions of a $5.6 trillion surplus. Once budgeters give in to some demands, the whole dike is likely to give way. As Pete Domenici, chairman of the Senate Budget Committee, puts it: “In truth, the challenge before this committee— indeed the challenge before the new administration and this new Congress—of reaching balance in a world of surpluses may be more difficult than it was in a world of deficits.”9 Of course, in January 2001, CBO was predicting that a $5.6 trillion surplus would be realized only if there is no major tax cut, no major increase in spending, the Fed cuts interest rates, and the economy grows at 3 percent per year. These are some pretty major assumptions, and everyone knows that developments will certainly depart from this scenario. The burst of spending by Congress at the close of the 2000 fiscal year pushed annual spending for that year far beyond the rate of inflation and above the spending caps in place under the 1997 budget agreement between President Clinton and the Republican Congress. That is very likely to happen again repeatedly over the next 10 years. Indeed, when CBO projects a large surplus, the behavior of the members of Congress will immediately change. As soon as politicians hear projections of huge budget surpluses down the road, the fiscal restraint imposed on them by the very budget rules that they themselves had drafted during the recent period of sustained deficits begins to weaken. There is a strong tendency for Congress to increase spending and reduce taxes in light of forecasts of decades of surpluses. If the behavioral response is great enough, the budget surpluses will never materialize. Likewise, it takes only one serious recession for tax revenues to fall well below the levels that budget forecasters have been predicting, thereby wiping out the projected budget surpluses in a flash. No one can predict with great certainty what the stock market, Congress, and Alan Greenspan will do tomorrow, let alone ten years from now. For this reason, policymakers should view all 10-year projections with a strong measure of skepticism and a grain of salt. To paraphrase John Nance Garner’s description of the vice presidency, a position he knew something of from firsthand experience, 10-year budget predictions simply are not worth a pitcher of warm spit. Despite such warnings, predictions of huge surpluses in the years ahead are construed as a green light by politicians, who have no shortage of ideas about what to do with all that extra cash. After years of belt-tightening and restricted spending, Democrats and Republicans alike began formulating plans for all the excess revenue pouring into the Treasury. This included Republican proposals 173

The Politics of the Surplus for a massive tax cut and increased spending on the U.S. military. It also includes proposals by Democrats to increase spending on Medicare and Social Security. Minor events such as an economic downturn or major “correction” in the stock market may dampen, but do not put an end to such proposals so long as the budget forecasters continue to predict trillion-dollar surpluses. Of course, the economy did slow in early 2001 and then slide into recession by the fall. This forced budget forecasters to revise their optimistic projections issued in January. In addition, the reduced revenues experienced on account of the Economic Growth and Tax Relief Reconciliation Act of 2001 forced CBO to lower its projections in its midyear budget update. In August, CBO lowered its prediction of a $275 billion surplus for fiscal year 2001 to only $153 billion, of which $162 billion would come from Social Security and Medicare. This would actually translate into a $9 billion on-budget deficit for the year. CBO also predicted that substantial on-budget surpluses would not materialize until fiscal year 2005. The 10-year baseline for 2002–2011 showed a $3.4 trillion surplus, which was $2.2 trillion less than the $5.6 trillion surplus that CBO had predicted only three months earlier in May 2001. Of this, only $847 billion would come from government operations; the rest would come from Social Security.10 The numbers got even worse after the September 11 terrorist attacks and the related economic disruptions. In September, CBO revised its forecast for fiscal year 2001 and concluded that the surplus would be only $121 billion, well below the $153 billion that CBO had predicted only the month before. By January 2002, CBO was predicting short-term deficits and a reduced 10-year surplus of only $2.3 trillion. Notwithstanding the lower figures for the short term, there still would be surpluses over 10 years, and the politicians knew what to do with the money. As recounted in chapter 5, increased spending and tax cuts were enacted by Congress in response to the terrorist attacks and stagnant economy. This assured that CBO would have to further reduce its projections of future surpluses. Perhaps the Age of Surplus had not yet arrived after all.

The Fiscal Crisis of Social Security Whatever the magnitude of CBO’s predictions of future budget surpluses, there is one very big number that is not included in the calculation—namely, the government’s unfunded liability for future Social Security payments. Notwithstanding recent budget surpluses and favorable long-term forecasts, Social Security faces a major revenue shortfall over the next 75 years. Estimates of the revenue shortfall range from $3 trillion to $11 trillion.11 Throw in Medicare and government pensions, and the unfunded liability of the federal government may reach as high as $6 trillion. Such estimates are based upon an analysis of demographics (the number of retired workers who will be entitled to collect Social 174

The Politics of the Surplus Security benefits), as well as future economic performance (which affects the revenue collected under the Social Security payroll tax). Only a small portion of these figures is reflected in the unified budget. Why does the budget not fully account for the government’s future obligations under Social Security? To answer that question, it is necessary to understand what the budget is and what it is not. The budget is prepared using a mixture of accounting procedures and methods, some required under law and others the product of convention. While prepared according to professional norms and standards, political interests are not irrelevant in the determination of which accounting rules are followed. Overall, the budget is merely a statement or measure of the government’s expected cash flow for the coming fiscal year under the particular set of accounting rules then in place. Similarly, the 10-year projection is an estimate of total cash flow over that period. A different set of accounting rules will produce different numbers. It also is important to remember what the budget is not. The budget is not a balance sheet, and hence does not reflect the enormous value of the vast assets owned by the federal government (e.g., all the public land and buildings owned by the federal government). Nor does the budget as a modified version of a financial statement include any accruals for the long-term unfunded liabilities of the federal government, but rather only those liabilities that are authorized (e.g., annual appropriations) or reasonably expected to be incurred in the forthcoming fiscal year. There is no accrual for a liability that does not become fixed and determinable for decades to come. Predictions of trillion dollar surpluses can mislead precisely because the budget does not include accruals for long-term liabilities. Most important, there is no accounting for the government’s obligation to pay Social Security benefits to current workers who will not retire until after the 10-year budget period— perhaps not for another 20 or 30 years. These workers may be fully “paid in” to the Social Security system, and hence already qualified for benefits. The only requirement is that they live long enough and reach the statutory retirement age. Under generally accepted accounting principles, a liability such as this would not be accrued on the books of a private business because it is much too uncertain with respect to the amount of the future payments, as well as with respect to those specific persons who are actually owed the money. Of course, GAAP is not applicable here—although actuarial accounting and common sense are quite relevant. Actuaries know with great confidence that a certain percentage of today’s workers will live to the age of 67 (the future retirement age), retire, and collect the Social Security benefits to which they are entitled under law. They also have very accurate estimates of the life expectancy of large groups of individuals, such as the millions of workers who presently participate in the Social Security system. Thus, the actuaries can predict with great certainty what the government will be paying retired workers payments over the next 75 years. When this is compared to the projected revenue that will be raised under the Social Security 175

The Politics of the Surplus payroll tax over the same period, a $3 trillion net liability appears on the horizon. The same kind of analysis reveals a huge deficit for Medicare, as well as unfunded liabilities for military and government pensions. That the government has an enormous liability to pay future Social Security benefits is not in question. That there will be insufficient revenue in the Old Age and Survivors Insurance (OASI) Trust Fund (commonly referred to as the Social Security Trust Fund) to cover this obligation is equally certain. However, only the projected Social Security surplus for the coming fiscal year (about $200 billion) is included in the federal budget. Only the government’s obligation to pay benefits to current retirees over the course of the next fiscal year is included in this figure, which represents the net of revenues over program payments for the year. Likewise, CBO’s estimate of $2.3 trillion of positive cash flow for the government over the next 10 years includes an extra $2.1 trillion coming from the Social Security Trust Fund. At the same time, this figure takes into account only the short-term positive cash-flow, but not the government’s $3 trillion unfunded long-term liability over 75 years to future Social Security beneficiaries. There is nothing devious or wrong about this, and it fully conforms with current budget accounting rules. However, this particular presentation of the government’s financial position gives a false sense of security to a great many people who are ready to spend or “give back to the people” current surpluses without taking into account the long-term obligations of Social Security. When those are taken into account, the financial future of the government does not look quite so rosy. While the fiscal integrity of Social Security is strong in the short-run, sometime after the next 10 years things will change dramatically for the worse. Even with current budget surpluses, estimates are that the cash flow from the Social Security Trust Fund will go negative by the year 2016, and the assets in the trust fund will be entirely exhausted by 2040. The financial position of the Disability Insurance (DI) Trust Fund is much worse. That fund is expected to be exhausted by the year 2026.12 The projections are equally depressing for the Hospital Insurance (HI) Trust Fund (commonly referred to as the Medicare Trust Fund), which is expected to become insolvent nine years before the Social Security Trust Fund. The combined Social Security and DI Trust Funds will be exhausted in 2038. Once the combined trust funds are exhausted, incoming tax revenue from the payroll tax will be sufficient to pay only about three-quarters of programs’ costs (i.e., benefits), declining to two-thirds by the year 2075. (The good news is that even after the trust fund runs dry, the federal government still will be able to pay future retirees a significant portion of their benefits out of receipts from the payroll tax.) Recent actions taken by Congress and President Clinton gave the government a few extra years before the revenue shortfall hits. However, the fiscal crisis still looms ominously on the horizon. In fact, under current law, Treasury cannot pay Social Security benefits except out of the trust fund, and so politicians will definitely have to take some action when those funds

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The Politics of the Surplus run dry. Of course, if they wait until the funds run dry to address the problem, it will be too late. The crucial question for the budget process is whether policymakers can muster the political will today to deal with this outstanding liability of $3 to $6 trillion that will come due over the course of the next 75 years. It is a tough call. Most likely, they cannot. Politicians are not particularly well-suited for addressing long-term fiscal problems such as this. Because congressman are constantly planning for the next election, whether two or six years down the road, it is difficult for them to focus on the long term (i.e., anything beyond the next election). The fiscal insolvency of Social Security and Medicare is still decades down the road. This is just too long a time frame for policymakers who have greater interest in focusing on current issues. The difficulty in taking a long-term perspective is compounded by predictions of huge surpluses for Social Security over the next 10 years. It really should be no surprise that the impending financial disaster for Social Security has been generally ignored by policymakers in Washington in the midst of their debate over how to spend surpluses that may or may not actually materialize. The last major effort to close the gap between future payments and revenue under Social Security was undertaken by Congress in 1983. At that time, the Social Security wage base was gradually expanded, the payroll tax was raised, and future benefits were indirectly reduced by postponing the retirement age for future generations of workers. Despite this effort at fiscal responsibility, which resulted in the temporary surplus in the trust fund, the ultimate day of reckoning for Social Security was merely postponed. The current on-budget surpluses provide the first real opportunity to resolve this problem and put Social Security on a sound fiscal foundation. Whether policymakers in Washington have any interest in using the projected on-budget surpluses generated over the next 10 years to “save” Social Security is highly questionable. Rather than face these hard issues, policymakers have used the Social Security surpluses for the past twenty years to fund other government programs, thereby masking the true extent of deficits in the 1980s and 1990s. So why should things change now?

Financing Social Security Social Security is by far the largest and most important of the so-called entitlement programs—programs for which spending is mandated by law and determined by the number of persons who qualify for the program, rather than annual appropriations by Congress. This kind of expenditure is also referred to as direct or mandatory spending. Spending on entitlement programs (which also includes Medicare, Medicaid, and food stamps) now totals over $1 trillion, accounting for over half of all government spending and some 10.5 percent of GDP. Social Security and Medicare together now account for over 40 percent of gov-

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The Politics of the Surplus ernment spending, leading economist Paul Krugman to quip that the federal government “has become a retirement program that does some military stuff and a bit of humanitarian stuff on the side.”13 The Office of Management and Budget estimates that entitlement spending will comprise 55 percent of all federal outlays in 2002, and rise to 67 percent by 2010.14 This spending lies outside the formal budget process and is much more difficult to control by the political process once the “right” to receive benefits has been established by law. Crafting Social Security benefits as a right also makes it nearly impossible for politicians to cut back or eliminate the program.15 Discretionary spending, which is under the jurisdiction and control of the budget and appropriations committees, now accounts for only one-third of government spending. The growth of entitlement spending has put great pressure on the entire budgeting process.16 As political scientist Ronald King puts it in his recent study of one entitlement program (food stamps): “[E]ntitlement status carves off a portion of total outlays and establishes them as relatively uncontrollable, responsive automatically to shifting social and economic conditions, not directly contingent on congressional specification, oversight, and adjustment.”17 While Congress potentially could repeal the entire Social Security program tomorrow, thereby solving the fiscal problem that lies ahead, political pressures make that impossible. Even cutting back benefits slightly and indirectly, as was done in 1983, is very difficult for elected politicians. It has not been attempted again since that time.18 Social Security involves a huge intergenerational transfer from current workers who are paying the Social Security payroll tax to fund the current payment of benefits to an older generation of retired workers.19 On top of this, the system as a whole works a progressive redistribution on account of the calculation of benefits, which favors those with lower lifetime wages by paying them disproportionately higher benefits.20 The great fiscal problem for Social Security lies in the significant change in demographics related to the expansion of the life expectancy of U.S. workers. This is good news and bad news. The good news is that Americans are living longer, and hence there are more retirees over the age of 65 than ever before. The bad news (for Social Security) is we are rapidly approaching the time when there will not be enough workers paying the payroll tax to fund current program expenses (i.e., retirement benefits). In 1945, five years after benefits were first paid, there were only 2 retirees collecting benefits for every 100 workers contributing to the trust fund. Today that ratio is roughly 30 retirees for every 100 workers, and is expected to increase to 50 retires for every 100 workers by the year 2031. This dramatic change in the retiree-toworker ratio is attributable to the significant demographic shift in the population—workers are living longer and collecting benefits for longer. In 1940, the proportion of the male population that lived to 65 years of age was 54 percent, while 61 percent of females lived that long. In 2000, the percentages were 76 for males and 86 for females. In the next fifty years, these numbers will 178

The Politics of the Surplus rise another 5 or 6 percentage points. Therein lies the impending fiscal imbalance in the program. Basically, Social Security is funded on a “pay-as-you go” (PAYGO) basis. This means that current workers pay for the benefits of current retirees. However, Social security is not entirely financed on a PAYGO basis. To the extent that the trust fund has been built up by years of surpluses since 1983, when payroll taxes were raised beyond what was needed at the time to fund payments of current benefits, there is now a “reserve” of nearly $1 trillion available to pay future liabilities. However, this is not a genuine reserve in that it is not funded by cash. Besides, $1 trillion is enough to pay the piper for only a very short while. Fiscal imbalance is built into the current system because of the unfavorable ratio of retirees to workers, and the reserve in the trust fund will be depleted in less than forty years. On account of this, “fixing” Social Security is no easy task. It is much easier to proclaim one’s devotion to Social Security than to actually make the hard choices necessary to put the system in actuarial balance. According to economist Henry Aaron of the Brookings Institution and former director of CBO Robert Reischauer, now president of the Urban Institute in Washington, there really are only three choices for accomplishing that goal, and all three may be necessary to truly fix the problem. First, benefits to participants can be reduced in some fashion. Second, a tax increase of some sort (whether income tax or payroll tax) can be adopted. Or third, returns on the trust fund can be increased.21 The third option was very popular a few years ago as the equity markets outperformed all other investments; however, enthusiasm seems to have cooled since the stock market slumped in early 2001.22 The first two choices are the most obvious ones. The Board of Trustees of the Social Security Trust Fund estimates that the program can be brought into 75-year actuarial balance either through a 13-percent reduction in benefits or a 15-percent increase in payroll taxes, or a combination of the two. However, neither choice is very appealing to policymakers who must face their constituents in November. Increasing taxes is never easy. But with combined payroll taxes already reaching 15.30 percent (the combined employee and employer shares), it may be impossible to increase the Social Security payroll tax any higher. Presently, almost three-quarters of all taxpayers pay more Social Security payroll tax each year than they do federal income tax. Likewise, raising income tax rates to supplement Social Security out of general revenue will be difficult in the present antitax climate. Furthermore, the obligation of the government to redeem its debt instruments that have been given to the Social Security Trust Fund in exchange for the surplus funds generated since 1983 already will put considerable pressure on general revenue in future decades. There are legitimate questions about whether the income tax could even raise enough money to bail out the Social Security Trust Fund this way.23 In the face of such tough choices, what one hears from politicians is mostly empty rhetoric about “saving” Social Security, but very little that will be really effective is offered. A quick look at the proposals of President 179

The Politics of the Surplus Clinton and the Democrats, as well as those put forth by Republicans in the last decade will confirm this. “Saving” Social Security As soon as the first surplus in thirty years was realized in fiscal year 1998, Democrats in Congress joined President Clinton in declaring that surplus revenues must be “dedicated” to Social Security. To say the least, the plan was sketchy. First, Clinton proposed dedicating 100 percent of the surplus to Social Security. Then in his January 1999 State of the Union address, the President proposed that $2.8 trillion (or 62 percent) of the budget surplus over the next 15 years be used to “save” Social Security. Of this amount, some $650 to $700 billion was to be invested in stocks, rather than Treasury debt instruments.24 Another 16 percent would be devoted to building up the trust fund for Medicare, and some 11 percent to shoring up the military and other unspecified “pressing national problems.”25 It is not exactly clear what Clinton meant by such declarations—probably nothing in particular. The problem with this approach is that the entire budget surplus realized in 1998 and 1999 was attributable to the Social Security payroll tax, and hence already was included among the assets of the Social Security Trust Fund. Clinton claimed that he would dedicate 62 percent of the (unified) surplus to Social Security over the next 15 years, thereby postponing the impending insolvency of the system until the year 2055. But the President was really “double-counting” that portion of the surplus which already belonged to the Social Security Trust Fund—namely, the $2.7 trillion that was projected to be accumulated over the next 15 years from the Social Security payroll tax and invested in Treasury debt obligations that already would be assets of the trust fund.26 As of January 1999, an extra $100 to $150 billion or so generated annually by the Social Security payroll tax went into the calculation of CBO’s 10-year budget baseline. So it is pretty hard to imagine exactly what current funds Democrats such as Clinton were planning to “dedicate” to Social Security. Separating Social Security from budget calculations, the on-budget surplus that CBO was then predicting was not even expected to materialize until fiscal year 2001.27 At the time President Clinton presented his plan to save Social Security, the accumulated on-budget surplus for the 10-year period from 2000 to 2009 was predicted to total only $787 billion. While a $787 billion surplus is not insignificant, and certainly was a real improvement over decades of deficits, no one really could have thought that it was sufficient to “save” Social Security. Furthermore, everyone connected with the budget process knows that 10-year forecasts (whether of surpluses or deficits) are highly unreliable for all the reasons discussed above. So this really was not such a bold plan after all.

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The Politics of the Surplus If policymakers wish to protect the Social Security system by enhancing the ability of the trust fund to meet its future commitments, then it would be most prudent to dedicate all surplus revenues (both the current Social Security surplus and any on-budget surpluses) to paying down the $5.6 trillion national debt—or at least, the $3.4 trillion of debt that is held by the public. To the extent this is done, the government will free future generations from the cost and burden of servicing a huge national debt that the current generation ran up. As the late Herbert Stein recommended, we should use the current Social Security surplus and any future on-budget surpluses to “reduce the federal debt, add to national savings and increase the ability of future generations to meet the demands they will face.”28 Certainly, one of the greatest demands that future generations of Americans will face is paying the $3 trillion revenue shortfall that awaits the Social Security system over the next 75 years. Indeed, it is only because federal budget calculations do not employ concepts of accrual accounting that we can conveniently ignore this unfunded long-term liability and speak of budget surpluses at all. The best thing that came out of Presidents Clinton’s proposal to save Social Security was that the politicians and public were finally waking up to the serious flaws in the financing for the most important domestic policy program. If the citizenry has started to grasp that much, other issues still confuse the general public, to say nothing of most of the members of Congress. For instance, some are genuinely shocked to learn that the nearly $1 trillion of accumulated assets owned by the Social Security Trust Fund are not sitting in a vault somewhere, invested in the stock market, or hidden under the mattress of the Commissioner of the Social Security Administration. Rather, these assets are invested in special debt obligations of the U.S. government. This does not mean that the government has “looted” the trust fund, as many demagogues claim. However, the excess receipts generated by the Social Security payroll tax have been borrowed and used by the federal government to fund other programs. True, the rate of return on those government debt obligations is not as great as the performance of the S&P 500 during the roaring 1990s—although it certainly was much better than what most investors saw for the past three years.29 Furthermore, lending to Uncle Sam is considerably less risky than investing in the stock market. After all, the “full faith and credit” of the federal government stands behind repayment of its debt obligations. While that may be worth something less than the personal guarantee of Bill Gates, it still runs a close second. Of course, the lending arrangement between Social Security and the Treasury necessitates that the federal government eventually repay its debt to Social Security. That can only be accomplished by raising taxes in the future, or alternatively, reducing retirement benefits. Since the latter is not a very attractive political option, and the Social Security payroll tax is pretty much at its upper

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The Politics of the Surplus limits, it most likely will be income taxes that must be raised. That is when the crunch will really hit—especially if antitax Republicans still control Congress! For the past two decades, the positive cash flow from Social Security has masked the true extent of the government’s overspending on other programs. That is less true these days, what with on-budget surpluses and a declining national debt. Today, the on-budget surpluses mask the coming financial crisis for Social Security. Eventually all the government notes held by the Social Security Trust Fund will come due. And when they do, unless Congress somehow manages to save whatever on-budget surpluses materialize over the next 10 years, the federal government will then have to either raise taxes or cut expenditures, or the Treasury will have to borrow from sources other than the Social Security Trust Fund (i.e., sell some more bonds to the public) to pay off the notes held by the trust fund. Any way you cut it, there is no free lunch—except perhaps for the parents of the Baby Boomers, who have enjoyed Social Security payments during retirement far in excess of their lifetime contributions to the system. Of course, the Baby Boomers themselves are paying a significant transfer fee (in essence, a tax) that funds the excess benefits bestowed upon their parents. In addition to Democratic proposals to save Social Security, there has been no shortage of innovative plans from Republicans who similarly think that they can save the program without either cutting benefits or increasing taxes. Truth be told, the overriding goal of most conservative Republicans is the privatization of Social Security. This is the objective, often left unstated, that Barry Goldwater let slip during the 1964 New Hampshire primary. Because Goldwater (and after him, Ronald Reagan in 1976) paid such a severe price for even intimating that Social Security ought to be “voluntary,” for decades thereafter Republicans avoided the issue like the plague. However, Republicans discovered more recently that they can touch the “Third Rail” and live to tell about it. Arguments in favor of privatizing Social Security became common fare for Republicans in the 1990s and no longer remained the exclusive domain of cloistered academics.30 Such a debate among politicians is possible only because the impending fiscal insolvency of Social Security is now becoming recognized. This is the only reason Social Security is even on the policy agenda. On the other hand, most Republicans still tread carefully, pushing “partial” privatization as their alternative to the current system. Furthermore, few proponents of privatization really mean that the government will get completely out of the business of sponsoring retirement plans, as there still is an important element of “forced” or mandatory savings under all these plans. Under this general rubric of partial privatization falls the plan advocated during the 2000 presidential campaign by George W. Bush, who proposed transferring 2 percentage points out of the 12.4 percent OASI payroll tax to private accounts managed by workers themselves. These private accounts would supplement, not replace, existing Social Security coverage. While Social Security has taken a backseat to Bush’s tax cut initiative 182

The Politics of the Surplus during the first session of the 107th Congress, the President has committed to raising the issue sometime later during his term. Indeed, in May 2001, the President appointed a bipartisan commission co-chaired by former New York Democratic Senator Daniel Patrick Moynihan and Dick Parsons, a Republican executive with AOL/Time Warner. Because the 16-member commission was composed entirely of those who already supported the President’s plan for partial privatization through worker private accounts invested in the stock market, expectations were that the commission would issue a favorable report supporting the President’s plan.31 Right on cue, during the second week of public meetings held in late July 2001, the commission made public its interim report in which private accounts were defended as a viable option for saving the Social Security system. This was certainly no surprise given the makeup of the commission. In the end, the 2002 midterm elections will determine how far Republicans can push their initiative. Virtually all such Republican plans for “supplemental” private accounts are modeled on a proposal first advanced by Harvard University economist Martin Feldstein, former chairman of President Reagan’s Council of Economic Advisers. Feldstein has long argued that Social Security reduces aggregate national savings, and years ago he proposed converting the current PAYGO system into a fully funded government retirement plan.32 More recently, Feldstein proposed setting up supplemental private accounts for workers.33 Under this plan, which many Republicans (including Feldstein) view as the first step in the total conversion of Social Security to a private retirement plan, the surplus would be used to fund tax-free Social Security accounts for individual workers. As individuals earn one dollar of investment return on these accounts, their Social Security benefits would be reduced by seventy-five cents, providing a windfall to both the government and the worker. The individual, as owner of his own account, would choose how and where to invest his account savings, as is the case with a so-called 401(k) retirement plan. In the worse case scenario, if a worker loses his entire individual account (say, on account of a crash in the stock market, or because he invested in Enron stock), his Social Security benefits would be no less than under the current system. Of course, the government could be much worse off under the Feldstein plan, as it would still be required to make up the loss. In essence, Feldstein’s plan relies upon the stock market and a booming economy to bail out the government and reduce its $3 trillion unfunded liability to future Social Security beneficiaries. But if the economy and stock market do not perform as anticipated (which is certainly possible given recent declines in both), the government will be left with the same $3 trillion Social Security shortfall, the surplus will be spent, and the national debt will remain undiminished. Then new taxes would need be raised or Social Security benefits cut to cope with the financial disaster. As liberal journalist Jonathan Chait describes the Feldstein plan: “This isn’t a solution to Social Security’s problem—it is Social Security’s problem.”34 183

The Politics of the Surplus In his fiscal year 2000 budget, President Clinton proposed his own version of a plan for private retirement savings accounts, albeit not as generously funded as that proposed by Professor Feldstein. Clinton’s alternative was Universal Savings Accounts (or “U.S.A. Accounts”), which were earmarked for those with incomes below certain thresholds (most likely, somewhere between $80,000 to $100,000). Under the Clinton plan, these savings accounts would be funded by the government, using some 11 percent of the surplus (over the next 15 years) to match the contributions made by an estimated 100 million participants. The accounts would be under the control of the individual participants, rather than the government.35 While purporting to create incentives for “savings,” U.S.A. accounts really would be little more than new entitlements for the middle class. These retirement accounts were aptly referred to as “some sort of governmentendowed Orwellian defined contribution plan.”36 Nevertheless, many Democrats liked the plan because it was targeted at low-income workers. Ironically, some Republicans liked it because it would return some portion of the surplus to taxpayers and would leave investment of the funds in the hands of individuals, rather than the government. Reportedly, some aspects of the plan were even agreeable to such diverse groups as liberal congressmen, free-market enthusiasts at the CATO Institute, and conservatives at the Heritage Foundation.37 None of these plans for private savings accounts, neither those proposed by Democrats nor Republicans, really solves the problem of Social Security, which results from the commitment to pay benefits in excess of what the system can raise through the payroll tax. Using on-budget surpluses to fund private accounts does little to correct that long-term imbalance, although at least Feldstein would reduce future benefits (and hence the government’s obligation) to workers who manage not to lose their share of the government’s contribution. But even that is too generous and too optimistic. If the on-budget surpluses dry up, there will be no way at all to fund the individual retirement accounts. Rather than turning to private accounts funded through the surplus or a portion of the payroll tax, it may be possible to stabilize Social Security by attaining a greater return on the assets held by the trust fund. This could be achieved by investing some portion of the assets of the Social Security Trust Fund in stocks and bonds that pay a higher return than the government debt obligations presently in the trust fund’s portfolio. Of course, Republicans who support private accounts do so because they also wish to privatize the system. Others support individual retirement accounts because there is a more direct link between what a worker contributes and what is received in benefits, as there is in a 401(k) retirement plan where each employee has an account under his or her own name. However, if attaining a higher rate of return on retirement investments is really the goal, this can be achieved without private accounts. While there is greater risk in private investment, that risk could be pooled among all participants if the trust fund does the investing, rather than individual participants. The risk that any particular participant might invest poorly and lose his retirement 184

The Politics of the Surplus funds would be eliminated. Professional fund managers could be engaged to invest a portion of the trust fund’s assets in stocks and bonds. This arrangement would alleviate concerns that the government itself would be investing in private markets and potentially asserting control over private business decision making.38 In making investment decisions regarding the mix of government debt obligations, stocks, and bonds purchased with fund assets, fund managers would be held to the “prudent investor” standard. Economist Laurence Seidman, who proposes such an arrangement, likens the result to a “[funded] defined-benefit plan in which each retiree’s benefit is linked to the retiree’s own wage history by a legislative formula; the benefit does not directly depend on the performance of the portfolio.”39 Seidman calculates that the payroll tax and the return on investments together would be sufficient to fund benefits, with each contributing about 50 percent of the revenue required to fund current obligations to retirees. Presumably, if this proves inadequate, to the extent that there is an on-budget surplus for a given fiscal year, that much could be contributed to the Social Security investment portfolio. Beyond this, there really are no other options for saving Social Security. In the end, it is a collective political decision about whether we wish to pay future generations of retired workers benefits at current levels, as well as provide senior citizens with the level of coverage presently offered under Medicare. If we decide that it is important to retain these benefits, or even increase coverage (for instance, by expanding Medicare to cover prescription drugs), then we must recognize that it is necessary either to raise taxes or attain higher rates of return on the investment of Social Security assets. Whether we wish to assume a greater degree of risk in investing the assets of the Social Security Trust Fund is also a political decision. At the same time, we must be prepared to supplement the Social Security and Medicare Trust Funds from general revenue sometime in the near future. This may only be politically feasible if there are on-budget surpluses. Alternatively, paying down the national debt will reduce the government’s obligation to make interest payments, thereby freeing up future revenue for Social Security and Medicare. On the other hand, if we decide that tax rates are already too high and that contributions from general revenue are unacceptable, as most Republicans believe, then we must reduce benefits to future retirees and seniors (i.e., today’s workers). There are no other alternatives. Even in the Age of Surplus, there are still limits to what government can accomplish.

Does Anyone Remember the Deficit? Notwithstanding the impending revenue shortfall for Social Security, it is beyond doubt that the economic position of the federal government has improved considerably in the past 10 years. While the economic boom of the 1990s contributed to the great increase in tax revenue collected by the government, there 185

The Politics of the Surplus were also some real changes in the way Congress budgets that played an important role in producing the new surpluses. To understand what contributed to the improved financial position, as well as how to avoid sinking back into unrestrained spending and deficits, it is necessary to figure out what budgeters did right in the 1990s to turn things around. A number of important rules and procedures were adopted in the 1990s that contributed to improving the way Congress allocates resources in light of available revenue. Abandoning these rules now on account of rosy, yet ephemeral predictions of future surpluses can only guarantee that those surpluses never materialize. The origins of the new rules for budgeting adopted during the 1990s can be traced to the significant budget deficits that followed in the wake of the tax reductions implemented under ERTA. While the Reagan administration took no decisive action on the budget deficit, Congress responded with its own deficitreduction legislation in 1982 and 1984. Then Congress took a dramatic step toward reversing course on budget deficits when it enacted the Balanced Budget and Emergency Deficit Control Act of 1985, commonly referred to as GrammRudman-Hollings (GRH).40 Gramm-Rudman-Hollings provided for gradual reductions in the deficit over the period from fiscal year 1986 through 1990 and a balanced budget by 1990. In 1987, the target balanced budget was postponed to 1993. In the end, it proved impossible to reach balance by any of these target dates. At the heart of GRH was a formidable provision providing an automatic sequestration of funds if the projected deficit exceeded the allowable target for that fiscal year. According to Joseph White and the late Aaron Wildavsky: “The essence of GRH was budgetary terrorism.”41 Despite the threat of monetary emasculation, GRH proved ineffective in reducing the deficit precisely because it required only that the projected deficit be within the target, rather than restricting the actual deficit. As a result, policymakers found easy ways to get around the GRH targets. According to budget expert Allen Schick: “Reliance on projected rather than actual deficits led to manipulation of budget estimates, bookkeeping tricks in lieu of genuine savings, and deficits much higher than had been budgeted.”42 Such tricks reduced projected budget deficits, but not actual deficits. If Gramm-Rudman-Hollings was less than successful in reversing the perennial budget deficits, important lessons were learned about how to cook the books to reduce projected deficits. The art of budget manipulation was perfected during the years under GRH and now is commonly applied to avoid the adverse effect of other restrictive budget rules. For example, budgeters know that revenue loss can always be pushed back to later fiscal years (the “out” years) through manipulation of the impact of a tax cut or expenditure. This is because the fiveyear cost of a revenue provision is computed on a cash-flow basis, rather than taking into account the present value of all the lost revenue.43 One of the best examples of this gimmick in recent years was the Death Tax Elimination Act of 2001 (H.R. 8), which kept the cost of repealing the gift and estate tax within 186

The Politics of the Surplus budgetary limits by scheduling long-term rate reductions, with total repeal not coming until after the 10-year window of the budget baseline. Likewise, revenue raisers can be created out of thin air through tax provisions that generate revenue in the current fiscal year, even while losing money for the Treasury in subsequent years. As long as the adverse effects of a provision are pushed far enough into the future (e.g., beyond the relevant OMB baseline), sequestration is avoided, politicians are happy, and life as usual goes on in Washington. Tax reduction for capital gains provides the most obvious example of such a manipulative budgetary device. These are generally scored as revenue raisers in the short term and revenue losers in the long term. But as long as the revenue loss is scheduled beyond OMB’s baseline, the tax cut can be enacted without violating the budget rules.44 On the brighter side, policymakers also learned an important lesson during the mid-1980s from their experience with the Tax Reform Act of 1986 (TRA).45 As part of the agreement that brought together supply-side conservatives looking for lower marginal tax rates and liberal Democrats intent upon stripping the tax code of loopholes and preferences, policymakers adopted a framework of “revenue neutrality” for the bill. It was agreed that the bill would neither raise nor reduce revenue overall, nor would the burden (or incidence) of taxation be shifted among taxpayers of varying income levels.46 This framework of revenue neutrality imposed a new set of constraints and a created a new pattern for policymaking that “effectively prevented many of these [special] interests from uniting against reform.”47 The result was that marginal tax rates were significantly reduced (to the delight of the supply-siders) and abundant tax expenditures were eliminated from the tax code (to the delight of everyone except the beneficiaries of those preferences). The success of revenue-neutral tax policymaking in 1986, although never replicated, provided a model for controlling a budgetary process seemingly out of control.

The Budget Rules of 1990 Notwithstanding efforts by Congress in the 1980s to check the excessive spending habits of its own members, budget deficits actually increased as a percentage of GDP by the end of the decade. By 1990, the economy was sliding toward recession, and concern over the federal deficit heightened. There was an emerging consensus that more drastic changes in the budget process were necessary. One favorable outcome of the infamous 1990 budget summit was agreement on new budget principles that were then codified under the Budget Enforcement Act of 1990. Therein the principle of revenue neutrality that had guided policymakers in 1986 during negotiations for TRA was fixed into a hard rule for budgeting. One of the most significant rules adopted under the Budget Enforcement Act of 1990,48 which amended the Congressional Budget and Impound187

The Politics of the Surplus ment Control Act of 1974,49 was the so-called pay-as-you-go (or PAYGO) budget rule. PAYGO imposed on Congress revenue neutrality with a vengeance and significantly altered long-standing patterns of tax policymaking. Under the PAYGO rule, any tax reduction must be offset by a comparable revenue increase, reduction in a current tax expenditure, or cut to “direct” discretionary spending programs; annual net revenue losses from all new legislation must be offset by revenue enhancement or direct spending cuts.50 Even more important, the PAYGO rule expressly bars Congress from so using a budget surplus to finance tax cuts (both across-the-board tax cuts and targeted tax preferences).51 You can finance tax reduction through cuts to entitlement spending.52 However, you cannot simply cut taxes to make the surplus go away. Nor can you give tax credits—whether for children, housing, education, or any other noble cause—without first coming up with the offsetting revenue. This creates a new “zero-sum” environment for tax policymaking, as interests competing for new tax subsidies are played off against other interests also seeking new tax subsidies or just trying to hold on to those they already have. The overall effect is to limit the growth of new tax expenditures, while creating incentives to eliminate existing ones (as a source of revenue offset for new tax cuts or expenditures). As Professor Elizabeth Garrett argues, the PAYGO budget rules are a “mechanism to harness the interest group activity that is already ubiquitous in the tax legislative arena in order to reach substantive policy goals more easily.”53 The substantive policy goals furthered by PAYGO are deficit reduction and responsible budgeting. Under the 1990 budget rules, if there is a revenue loss for the fiscal year as a whole, determined by reference to the annual fiscal-year budget baseline set by the Office of Management and Budget (OMB), sequestration of discretionary spending is imposed automatically. Social Security, as an entitlement program funded through mandatory spending, is unaffected, as is spending that is deemed an “emergency” authorization by the President and Congress. For everything else, the Budget Committee is authorized to report a “pay-as-you-go reconciliation directive” in the form of a concurrent resolution whenever any legislation creates a net revenue reduction for any fiscal year—in other words, when there is no revenue offset “within the same measure.”54 This PAYGO rule, which requires annual revenue offsets, was translated by Ways and Means Committee Chairman Dan Rostenkowski and Senate Finance Committee Chairman Lloyd Bentsen into a practice within both tax committees whereby any single legislative proposal that costs revenue must be coupled with an offsetting revenue raiser in the same bill. The tax committees have continued to adhere to this procedure in the years subsequent to the departures of Messrs. Rostenkowski and Bentsen from the Congress. On top of this, the Senate follows the so-called Byrd rule in addition to the PAYGO requirement for revenue neutrality. This parliamentary rule, devised by West Virginia Senator Robert Byrd, requires that any “extraneous” provision in a budget bill (i.e., one not having significant budgetary 188

The Politics of the Surplus revenue or spending impact) be stricken unless 60 senators vote on the floor of the Senate in favor of retaining such provision.55 The Byrd rule and PAYGO have been highly effective in blocking the inclusion of new tax cuts and tax expenditures in budget bills. To solve the dilemma imposed upon antitax Republicans by these restrictive budget rules, a number of leading members of Congress from the GOP began in the mid-1990s to call for the abandonment or modification of the offending provisions. In particular, former House Budget Committee Chairman John Kasich proposed repealing PAYGO so Congress could enact deep tax cuts.56 Along similar lines, two influential members of the Senate repeatedly called for modifying the 1990 budget rules. Former Senate Finance Committee Chairman Bill Roth (R-De.) and Senate Budget Committee Chairman Pete Domenici (RN.M.) both expressed interest in relaxing these budgetary rules to allow for tax cuts funded by surpluses. The logic was clear to Roth, who declared: “We have surpluses and the rules ought to be updated to meet the current situation.”57 Meanwhile, Domenici proposed changing the rules to allow any on-budget surplus (not including surpluses arising from Social Security) to be devoted to tax reductions.58 Roth’s antitax message was no surprise, but Domenici’s position represented a distinct about-face. For years, he had been a bulwark within the GOP for fiscal responsibility—an increasingly quaint and all but extinct tradition once popular among congressional Republicans, especially those from the Northeast and Midwest, but definitely not common among the new breed of antitax Republicans from Texas. Domenici’s new found enthusiasm for tax cuts gave the antitax wing of the GOP an important boost, while simultaneously undermining the anti-deficit position he himself had advanced for decades. It also turned the tables on the debate over repealing or preserving the 1990 budget rules. In another one of those wonderful ironies of politics, seven ranking Democrats on the Senate Budget Committee (none of whom would be referred to as “bulwarks of fiscal responsibility”) wrote to Chairman Domenici urging him to refrain from abandoning the PAYGO rule on the grounds that to do so would “undermine Congress’s fiscal discipline.”59 Talk about the Old Switcheroo! Obviously, Republican bulwarks of fiscal responsibility are just not what they used to be. So with old-time fiscal conservatives such as Bob Dole gone from the Senate, and fellow fiscal conservatives such as Pete Domenici realigning themselves with the House crusaders for tax cuts, pressure has mounted to abandon the 1990 budget rules that helped create the surpluses that the antitax Republicans so desperately seek to “give back” to the American taxpayer. Repealing or significantly modifying PAYGO, or just avoiding it by suspending the rules through parliamentary procedure in order to enact tax cuts, is necessary for antitax Republicans since it is otherwise impossible to finance such massive tax cuts within the framework of the current budget rules. There simply is not enough “fat” left in the federal budget for expenditure reductions to finance 189

The Politics of the Surplus significant tax cuts, and likewise, it is getting virtually impossible to come up with new revenue to offset even minor tax expenditures, let alone the sort of large-scale tax cuts envisioned by the antitax wing of the Republican party. Unfortunately, with the repeal of PAYGO will go any hope of a “real” surplus ever materializing. The point lost on critics is that the very success of the 1990 budgetary rules has, along with the booming economy, made possible the budget surplus that they are now looking to give back to the taxpayers through tax cuts. Abandoning PAYGO before significant on-budget surpluses even arrive will only ensure that there never is any surplus cash available for either tax cuts or increased program spending, as the heightened discipline achieved in the budget process during the 1990s was largely attributable to rules such as PAYGO. The main achievement of the 1990 budget rules was to impose a new framework for responsible policymaking on those in Congress entrusted with writing our tax laws. PAYGO checks the natural impulse of Democrats to spend more than the government actually takes in, and likewise, restrains the deep-rooted instinct of Republicans to shelter its well-heeled constituents from the income tax. In this respect, the 1990 budget rules were a great success as politicians of both parties were forced to work within the framework of budget neutrality. Nevertheless, just because PAYGO goes far in checking the inherent political impulses of politicians to run up deficits does not mean that the budget process is working exactly the way it should. First of all, conservative critics are right in suggesting that if the government continually raises significantly more than it spends, something is out of alignment. Of course, in determining whether in fact the government is really raising more revenue than it spends, it is necessary to use a system of accounting that takes into account the long-term unfunded liabilities of the government, such as those relating to Social Security. The $5.6 trillion surplus over ten years can be viewed as the unforeseen outcome of using accounting methods that have too short a timeframe. The problem may be that our 10-year framework for budgeting is too short, not that taxes are too high. Still, it is quite possible for the government to run up surpluses that are too large as a percentage of GDP, thereby having a negative affect on the economy. Exactly when an excessively large surplus will push the economy to recession is an open question—just as it is unclear how long it takes for sustained deficit spending to negatively affect the economy.60 Most economists presently believe that the Federal Reserve Board is capable of offsetting the contractionary effect of the surpluses that are currently projected through lower interest rates. But even if surpluses prove to be excessive and contractionary, that need not be an indication that the government is taxing too much, as antitax Republicans presumptively conclude. It may mean that the government is not spending enough—for example, not spending enough on public goods that are desired and necessary for maximum economic efficiency.61 Surpluses may be prima facie evidence that taxes are too high, but the real problem could be that the government is not spending enough on infrastructure, 190

The Politics of the Surplus national defense, or any of the other public goods for which government expenditures are required. The current crop of Republicans has had little experience dealing with such problems. (We should always have such “problems” as excess revenue and surpluses, whatever the explanation.) The last time that a Republican Congress faced the dilemma of how to spend surplus revenue was during the 1880s and 1890s, when the tariff generated perennial budget surpluses. In 1883, the eclectic economist Henry George pointedly observed that on account of the revenue brought into the federal Treasury by the tariff, “the great question before Congress is what to do with the surplus.”62 The GOP’s solution then was to get rid of the excess cash by continually increasing the pensions of Civil War veterans—at least, those who wore blue uniforms. It is doubtful that the modern Republican party would find such a scheme very inviting, although increasing military salaries and pensions are a viable option. But these days, tax cuts have the greatest appeal within the Republican party. If Republicans are shortsighted in calling for the abandonment, modification, or suspension of the PAYGO rule just so they can pass their tax cuts, they are not entirely mistaken in calling for reconsideration of the 1990 budget rules. They are merely focusing on the wrong issue. The real problem with PAYGO is that the requirement for revenue neutrality has imposed a very peculiar and undesirable pattern of policymaking on the federal income tax. The adverse effect on tax policymaking, not the need to implement massive tax cuts, warrants a reexamination of the budgetary rules adopted in 1990. This may or may not dictate that modifications to the PAYGO budget rule are warranted. Surely there will be a close call regarding whether the benefits of budgetary discipline derived from PAYGO outweigh the adverse effects resulting from revenue-neutral tax policymaking. Appraising the success and continued usefulness of the PAYGO rule requires an assessment of what revenue neutrality has done to tax policymaking over the past decade. To understand just what is wrong (as well as right) about the budget rules, it is necessary to step back and recall the particular political and economic context in which they were adopted—namely, perennial budget deficits and a mounting national debt. Of course, such recollection requires a memory that extends back beyond the current fiscal year—something sadly lacking in Washington these days.

Revenue Neutrality and Tax Policy Operating within the strict framework of revenue neutrality formally adopted as a budget rule in 1990, members of Congress were forced to weigh the respective equities between various preferences for special classes of taxpayers, rather than just offer preferences without regard to the consequences for the deficit. This limits the options available to those making tax policy: “[R]evenue neutrality 191

The Politics of the Surplus altered the tax-writing process. Prior revenue bills were often constructed through political logrolling, whereby special interest provisions were added one to the next, until a winning coalition was achieved. As intended, revenue neutrality converted this process into a ‘zero-sum game’: each interest was in competition with all others.”63 Thus, the traditional mode of tax policymaking was altered as “the constraints of producing a revenue-neutral bill forced the distributive politics of taxation into a redistributive mold.”64 The zero-sum game for revenue bills that is mandated of the congressional tax committees by the 1990 budget rules is the hallmark of contemporary tax policy. The ability of Congress to enact tax preferences is much harder. This is the beneficial side of PAYGO. Unfortunately, the new revenue-neutral policymaking has also produced some pretty strange-looking tax legislation. This has been illustrated numerous times since 1990. A look at some of the more dramatic, peculiar, and perverse products of revenue-neutral policymaking will help make the case against PAYGO. At the same time, we must admit that tax policymaking has often been unprincipled and ill-conceived throughout the postwar era. So while it may be tempting to blame PAYGO for so much that is wrong with contemporary tax policy, that is too extreme. PAYGO has just made some things a bit worse, even while improving the overall process.

PAYGO and Perverse Revenue Raisers PAYGO requires that every tax cut or tax expenditure must be offset by a reduction in spending or an offsetting revenue raiser, and the tax committees operate under a rule requiring that every reduction in tax be offset by a matching revenue raiser in the same bill. This makes for revenue-neutral legislation and revenue-neutral budgeting. However, as a framework for tax policymaking, revenue neutrality has produced very different outcomes from those achieved in 1986. Then, revenue neutrality translated into lower marginal tax rates as policymakers eliminated tax preferences. For each special provision (i.e., deviation from a “normal income tax”) stripped from the tax code, marginal rates were reduced accordingly. The overall result was a single omnibus tax bill pursuant to which a significant number of tax expenditures were removed from the income tax code and marginal rates were dropped from 50 percent to 28 percent—at least for a while. But the PAYGO rule had a very different impact upon tax policymaking in the 1990s. During the 1990s, politicians (Republicans and Democrats alike) returned to their “old” pre-1986 habits, regularly giving in to the instinctual urge of all politicians to dream up new tax preferences for constituents and to implement partisan policy agendas through the tax expenditure budget. But now under the new budget rules, for each revenue loser created, a matching revenue offset had to be found. In the largely Democrat tax bills of 1990 and 1993, the offsetting 192

The Politics of the Surplus revenue was achieved by raising the marginal tax rate—a reversal of the 1981 tax cut and unwinding of the “reform” policymaking of 1986. That was bad enough. But in the wake of the new antitax Republican majority that emerged following the November 1994 elections, it became political suicide to propose tax rate increases. And so, where was the revenue to come from to finance new tax preferences? From some of the strangest places, that’s where! Existing tax expenditures without strong constituencies supporting them became fair game. The Tax Expenditure Budget published each year by the Treasury Department became a hit list for those looking for such revenue sources. Likewise, government benefits were eliminated to groups that politicians took for an easy target. Modifications to existing tax provisions were proposed and enacted with no justification, logic, or guiding principle other than to squeeze a few million bucks out of the tax base. Deductions were trimmed, phased out for upper-income taxpayers, or deferred for no other reason than to raise revenue, even if the tax code was needlessly complicated and the very computation of taxable income was thereby distorted. The worst is that revenue-neutral tax policymaking results in double damage: both the proposed tax preference and the offsetting revenue raiser mangle the income tax. In the good old days before PAYGO, we just got tax preferences and the deficit.65 We now have a balanced budget, even surpluses, and a tax code that is undermined twice as much by the odd coupling of unwarranted tax preferences and misconceived revenue raisers. This point can be illustrated by focusing on a few of the more dubious revenue raisers created by Congress during the 1990s. These reflect Republican and Democratic shortsightedness in equal measures. One perfect example is found in the bill that grew out of concern by Congress that too many American families that hire a nanny or babysitter end up breaking federal law—as had Zoe Baird, President Clinton’s failed first nominee to be Attorney General. The failure to withhold income taxes and Social Security payroll tax from domestic workers is widespread and common among otherwise law-abiding citizens, some of whom find themselves nominated to high level positions in the executive office. To avoid creating a nation of tax cheats, in 1994 Congress amended the treatment of domestic workers for purposes of Social Security payroll tax—the so-called nanny tax reform bill.66 The revenue loss attributable to this reform was minor, but PAYGO required a revenue offset. Congress found the money to pay for nanny tax reform by limiting the payment of Social Security benefits to incarcerated criminals and the criminally insane confined to mental institutions by court order. Policymakers found these groups an easy target, lacking both political clout and financial resources. Of course, these inmates in prison and mental institutions also do not vote very often! And so, a few million dollars were raised to get middle-class tax cheats off the hook by cutting the Social Security benefits of gray-haired cons and the criminally insane. As was recounted in chapter 4, major tax legislation was enacted in 1997. The Taxpayer Relief Act of 199767 and the Balanced Budget Act of 199768 were 193

The Politics of the Surplus both signed into law by President Clinton on August 5, 1997. The legislation included numerous tax preferences that required revenue offsets under PAYGO. A number of these were reform measures suggested by Treasury and aimed at perceived abuses of the corporate reorganization provisions found in the tax code. These corporate reorganization reforms raised $2.3 billion over 10 years. That this kind of technical revision of the tax laws designed to shut down abusive transactions also raises revenue for the Treasury makes them popular in Washington and greatly increases the chance that they will be included in tax legislation, whether proposed by Democrats or Republicans. This is the silver lining to revenue-neutral policymaking. But once again, a significant number of dubious revenue raisers also made their way into the tax code in 1997 via the requirement for revenue neutrality. By far the most significant revenue raisers in the 1997 tax act were extensions and modifications to expiring federal excise taxes, in particular the domestic air passenger ticket tax ($61.5 billion over 10 years) and the international departure tax ($11.9 billion over 10 years). By the slight of hand of renewing and modifying these previously enacted excise taxes scheduled to expire under prior law, Congress magically “raised” some $88.5 billion of “new” revenue over 10 years. In comparison to the excise tax extensions, all the other revenue raisers in the bill amounted to peanuts. But they do illustrate how tinkering with existing provisions can raise money for the Treasury. Of greater significance for tax policy was the reduction of the 5-year carryback period for net operating loses (NOLs) to 2 years, which raised $1.67 billion over 10 years (even while increasing the carryover period to 20 years). Modifications to the tax treatment of companyowned life insurance policies raised another $2.2 billion over 10 years. A companion bill, H.R. 2015, contributed $16.6 billion over 10 years through an increase to the federal excise tax on tobacco products. The Internal Revenue Service Restructuring and Reform Act of 199869 also included a host of bizarre revenue raisers. The original legislative initiative that emerged from committee was typical of the grab-bag tax legislation enacted in recent years as Republicans succeeded in turning the IRS restructuring measure into an omnibus tax bill.70 At the heart of the bill was the IRS reorganization plan. The legislation also included several new taxpayer protections (i.e., provisions expressing the GOP’s wrath for the IRS). None of this was very expensive. However, some other provisions that found their way into the legislation carried a more significant cost. For example, a provision originally included in the bill at the instigation of the Treasury altered the taxation of employer-provided meals. Lobbyists for the gaming and hospitality industries opposed this measure, and a greatly watered-down version was substituted. However, this still carried a cost of $316 million over 10 years, as estimated by the Joint Committee on Taxation.71 The final version of the bill ended up providing more favorable tax treatment of employer-provided meals than that afforded under pre-1998 law.72 Another significant provision was added to the 1998 act at the last minute in Conference 194

The Politics of the Surplus Committee. Ways and Means Committee chairman Bill Archer came through on his promise to repeal the 18-month holding period for long-term capital gains. Reducing the 18-month holding period to 12 months carried a cost of over $2 billion over 10 years.73 Funding for the many revenue losers included in the 1998 tax act (which the Joint Tax Committee scored as costing a total of $13 billion over 10 years) was achieved largely through two measures. The first and most dishonest, liberalized the rules for converting a traditional IRA into a new Roth IRA for senior citizens earning more than $100,000. By so relaxing the conversion rules, more taxpayers would qualify for the conversion and more money would come out of their traditional IRAs and into new Roth IRAs. That there is little evidence to suggest that Roth IRAs or tax-preferred savings account of any kind produce any increase in investment or savings for retirement is irrelevant to staunch proponents of these tax expenditures. Ideology is the driving force behind such tax preferences.74 Beyond such ideological devotion lies another motive behind Congress’s decision to aid Senator Roth’s personal crusade to expand eligibility requirements for the new IRAs. The conversion was so inviting because it actually raised revenue because income tax would be triggered on the withdrawal of savings from traditional IRAs. In the long-run, these IRA conversions cost the Treasury, since the funds reinvested in a Roth IRA are afforded a more favorable tax treatment. Conveniently, the long-term cost of the new conversions showed up outside the time frame of federal budgeting. Thus, the conversion provision was scored as a revenue raiser bringing in more than $8 billion over 5 years.75 This is the kind of ingenious provision that defeats the purpose of PAYGO and leaves future Congresses paying for today’s indulgences. The new conversion rule financed the many ill-conceived tax preferences included in the bill, thus doing double damage to the tax code. The second major revenue raiser in the 1998 tax legislation overturned the much criticized decision of the U.S. Tax Court in Schmidt Baking Co. Inc.76 In that case, the tax court had allowed the company to deduct more than $2 million of accrued (but unpaid) vacation and severance compensation that was secured by a standby letter of credit. Legislative repeal of Schmidt Baking was projected to raise some $3.2 billion over 5 years.77 It is possible that Congress was sincerely offended by the treatment bestowed upon the taxpayer in Schmidt Baking. But the more cynical among us will suspect that some clever staff member on Ways and Means or Finance grasped the true importance of overturning the Tax Court—raising revenue to pay for the many tax expenditures included in the 1998 tax act. The White House had proposed several revenue-raising provisions that did not make it into the 1998 tax legislation. These would have changed the way life insurance companies calculate reserves, regulated the use of family limited partnerships in reducing federal gift and estate tax liabilities, and eliminated the use of Crummey powers in planning for the gift and estate taxes. All of these 195

The Politics of the Surplus reform measures, which had their origins in the Treasury Department, faced strong opposition from well-organized business interests—most particularly, the insurance industry. This political pressure turned out to outweigh the revenue pressure exerted by PAYGO. In the end, congressional Republicans succeeded in excluding all three proposals from the final bill. The avalanche of perverse revenue raisers enacted to finance tax preferences continued throughout the decade. PAYGO certainly did not stop politicians from using tax preferences to implement their favorite public policies. For example, the tax credits proposed by President Clinton in his fiscal year 2000 budget carried a significant price tag. His proposal for a $1,000 tax credit for the care of a dependent relative was estimated by the Treasury to cost $5.5 billion over five years, with additional provisions in his initiative for long-term medical care pushing the total to $6.6 billion.78 This was by far the most expensive tax expenditure in the President’s budget package. New tax credits to encourage investment in underdeveloped urban and rural areas were estimated to cost another $1 billion over 5 years. The rest of the package included a host of lesser, although collectively significant revenue losers: tax credits for consumers who buy fuel-efficient automobiles; tax credits for employers who improve adult literacy (costing $100 million over 5 years); and tax credits to encourage employers to retrain blue-collar workers. On top of this, the administration’s proposed tax credit to aide the ailing U.S. steel industry with a 5-year NOL carryback carried a cost of $500 million over 5 years. The carryback period for NOLs had just been reduced to 2 years under the 1997 tax act. The decision in 1997 to shorten the carryback period to 2 years was driven strictly by the need for revenue to finance the 1997 tax cuts. Suddenly in 1999, the administration concluded that the 5-year carryback period had to be reinstated—although only for the steel industry. Apparently, other ailing industries were not worthy of this special tax treatment. Or perhaps they did not donate enough to the President’s legal defense fund. Of course, Clinton’s proposal to extend the carryback period for the steel industry also cost money, and so yet additional revenue raisers were needed to finance the new tax preference. There were a number of sources of new revenue in the President’s proposed budget, totaling $78.4 billion over 5 years. The bulk of the revenue came from increased taxes on tobacco users and producers ($34 billion over 5 years). Other revenue raisers included: an increase in the penalty for large corporations for a substantial understatement of tax ($657 million over 5 years); taxing previously untaxed profits of stock life insurance companies currently accounted for in an undistributed “policyholders surplus account” (PSA); and the taxation of investment income of trade associations ($1.4 billion over 5 years). The administration also stumbled upon several new revenue raisers of even more dubious merit. One of the President’s proposals denied a business deduction to a taxpayer who pays punitive damages, whether upon a judgment or in settlement of a claim. Even worse, to the extent that the punitive damages 196

The Politics of the Surplus are covered by insurance, any amount recovered from the insurer must be included in the gross income of the taxpayer.79 These are the kind of provisions that raise additional revenue for the Treasury by squeezing just a bit harder on previously identified and tapped sources of revenue. But beware! Eventually, the government can squeeze a bit too hard and end up triggering a behavioral response. For example, there is a limit on how much tax revenue can be raised from tobacco users before they switch to clove cigarettes or give up the nasty habit altogether. Experience with the 1990 excise tax on luxury commodities suggests that there are limits inherent to raising revenue through a commodity-specific tax imposed on nonessential luxury items—although it helps if the consumer is addicted to the product. (This is what economists refer to as highly “inelastic” demand.) In the case of the 10-percent luxury tax on furs, jewelry, yachts, and private planes, projected revenues failed to materialize, and the tax was eventually repealed other than on high-end automobiles. To raise additional revenue for the fiscal year 2000 budget, administration officials reportedly “scour[ed] the tax code for months in search of perceived abuses.”80 This search for “abuses” to shut down was motivated more by the need for some $34 billion of revenue to finance the President’s package of new tax goodies, and less by a deep-rooted concern for defending the integrity of the tax code—which used to be the role of the Treasury Department. However, this is actually the “good” side of revenue-neutral tax policymaking: it puts a premium on antiabuse provisions that raise revenue, but otherwise might not find sufficient political support to be included on the policy agenda. Many of Treasury’s antiabuse revenue provisions corrected unintended loopholes in Subchapters K and C, which checked tax shelter promoters who pounce upon every glitch in the arcane partnership and corporate tax statutes in order to manipulate them for the benefit of their clients.81 Another antiabuse revenue raiser in the President’s budget restricted the ability of U.S. corporations to make use of losses of a foreign corporation in which the U.S. corporation has acquired a 10-percent or more interest.82 Other proposals would crack down on corporate tax shelters. Unfortunately, searching for “abuses” to shut down in order to raise revenue to finance targeted tax cuts for the steel industry makes for some pretty misguided tax policy, even by contemporary standards.

Where Do We Go from Here? Projections of forthcoming decades of surpluses have thrown budget and tax policymakers into a tizzy. Republicans and Democrats alike have already decided how to spend the “excess” revenues that have not yet arrived. The Bush administration gave a good chunk of it back to the taxpayers in the form of a $1.35 trillion tax cut; Congress has already earmarked a good portion to new spending 197

The Politics of the Surplus programs. Whether used to fund tax cuts or new tax expenditures, the surplus is the politician’s best friend. And in this case, the 1990 budget rules are his worst enemy. But from the perspective of fiscal conservatism, the 1990 budget rules have had an important impact on the budget and tax policymaking processes— mainly by restraining the profligate impulses of congressional policymakers, both Democrat and Republican alike. The downside is that PAYGO has contributed to the glut of unwarranted, unfathomable, and overly complex revenue raisers enacted in the 1990s. Not that Congress did not pass this kind of tax provision before 1990, but PAYGO has definitely contributed to the increased volume. Nevertheless, the benefits of PAYGO outweigh the adverse effect of ill-advised revenue raisers. PAYGO checks the natural instincts of Democrats to overspend and Republicans to blithely slash taxes for their well-heeled constituents. The result has been a much needed dose of fiscal restraint for the budget process. Budget surpluses, and consequently, paying down a good deal of the national debt, are now a real possibility. We are even entitled to a brief moment of celebration. But not for too long! Until we provide for the $3 trillion unfunded liability of Social Security and pay off some of the $5.6 trillion national debt, we should not make too many demands upon the projected budget surpluses. Certainly, repealing PAYGO at this time would be imprudent. But who knows what imprudence the political process may render? If antitax Republicans have their way, PAYGO will be history. Most likely, PAYGO will be ignored (by suspending the rules, as Congress does whenever it no longer wishes to be bound by its own procedures) with respect to on-budget surpluses, and both tax cuts and new spending programs will be enacted. In Washington politics, “Plus c¸ a change, et plus c’est la mˆeme chose.”

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Conclusion

The Prospects for U.S. Tax Policy We are doomed to make hard choices. Politicians hate to make hard choices. So they make easy choices and they make a hard tax system —Former IRS Commissioner Sheldon S. Cohen Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies. —Groucho Marx (1977)

Federal tax policy changed dramatically after 1980. Prior to that, the long period of Democratic dominance over the party system that began with the New Deal had produced a fairly stable, albeit flawed tax policy. It was a distinctly Democratic tax policy, although the tax policymaking process favored numerous Republican interests as well. Indeed, it was a policymaking process that generated tax benefits for major, organized interests in both parties—business and labor alike. With the electoral victory of Ronald Reagan in 1980, decades of Democratic hegemony over the tax policymaking process ended, and a clearly identifiable Republican tax policy emerged. Mostly, it was based on the singular premise of lowering taxes. In fact, it is difficult to think of any other feature that so distinctly characterized Republican tax policy in the twentieth century. Under the guise of supply-side economics, proinvestment tax policy, or hostility to the federal government in Washington, Republicans have pushed for significant tax cuts whenever they have controlled the reins of the power. The tax cuts enacted in 1981 and 1986 remain the legacy of the Reagan years, just as the major tax cuts enacted in 2001 are already the most significant achievement of the new Bush administration in domestic policy. Tax policy was erratic throughout the 1980s, as Republicans cut taxes and then raised them again in the matter of years in response to soaring budget deficits. While Ronald Reagan certainly did cut taxes, he never quite got a handle on how to reduce Big Government in Washington. The result was historic deficits and fiscal instability for the federal government, even while the rest of the country enjoyed economic prosperity. Perhaps conservative Republicans would have resolved the conflict between their antitax policies and budget realities if 199

The Prospects for U.S. Tax Policy they had enjoyed a sustained period of rule over the federal government. Instead, the Democrats regained control of Congress, and soon after, the presidency. Throughout the 1990s, the two major parties constantly battled over the budget and tax policy. The decade began with a Republican president, George H. W. Bush, wrestling with a Democratic Congress over the direction of tax policy and the budget. Stalemate was reached in 1992 when Bush vetoed a Democratic tax bill. After the election of 1992, the Republicans lost their hold on the White House, and Democrats again enjoyed a brief period of political dominance. They made the most of it—sticking it to the constituency of the GOP in 1993 as they raised taxes on high-income taxpayers. There are Republicans who still cannot sleep at night because of the 1993 tax act. However, the evenly divided electorate soon moved back to the Republican party. With the major victory of the GOP in the 1994 congressional elections, the Democrats once again lost control of the legislative process. For the first time in 40 years, Republicans had a real opportunity to change the direction of tax policy. In fact, congressional Republicans tried to radically alter the federal system of taxation beyond any previous efforts. However, because a strong Democrat remained in the White House, political deadlock, rather than fiscal revolution resulted. For the rest of the decade, the Republican-controlled Congress contested the Clinton administration on everything related to tax policy and the budget—and just about everything else as well. Even impeachment by the House and a close encounter with removal by the Senate did not weaken the President’s determination to veto Republican tax bills. And veto he did! But rather than a mark of distinction, President Clinton’s recurring veto of Republican tax bills is but the sad symbol of the conflict and deadlock that gripped tax policy in the 1990s. The election of George W. Bush as President and the tenuous hold of the Republican party over the 107th Congress hinted that antitax Republicans might be able to take control over the tax policymaking process. Indeed, major tax-reduction legislation was enacted in May 2001, and a more minor tax cut was passed in November 2001. However, Republicans no longer controlled the Senate after June 2001, and the projections of huge budget surpluses that fueled tax-cut fever in May 2001 quickly faded from the charts. It remains unclear how long the antitax wing of the GOP will be able to hold on to the reins of power in Washington. In many ways, such contentious battles between Democrats and Republicans over tax policy are inherent to the American political system. The very structure of the American political system creates conflict (and occasionally deadlock) over tax and budget policy. Our political institutions are divided and weakened by excessive checks. In the Madisonian system of checks and balances, the Senate checks the House, Congress checks the White House, and the states collectively check the federal government, and vice versa. In the extraconstitutional party system that has evolved since 1800, Democrats check Republicans, congressional Democrats check Democrats in the White House, congressional 200

The Prospects for U.S. Tax Policy Republicans check Republicans in the White House, and interest groups check policymakers whatever their political persuasion when government challenges their economic position. On account of our system of checks and balances and the pluralist politics that prevails over our political system, whenever tax legislation is actually passed, it invariably includes something for everyone, and thus lacks principle, integrity, and coherence. As a consequence, every time there is major tax legislation, the tax code gets mugged. Our political institutions impose conflicting demands upon congressional policymakers—requiring them to raise revenue through the income tax, and at the same time, motivating them to enact special tax provisions to implement their partisan policies, as well as cultivate relations with constituents. When the income tax is used by policymakers to implement public policies and give economic benefits to constituents, the Treasury is inevitably deprived of revenue. That is the origin of the budget deficits that were endemic throughout the postwar era. To complicate matters, federal tax policy has been made for the past quarter century within the context of the strong antitax ideology that emanates from the Republican party. Of course, many good things result from this. For instance, it is very difficult to raise taxes in the United States, and there is an upper limit on what tax burden the government can impose on the citizenry—at least, in peacetime. The antitax sentiment in the Republican party provides a beneficial check on how far the coercive powers of the American state can be extended through the exercise of its power to tax. The other great check on the federal government’s power of taxation is the politician’s interests in using the tax code to lower taxes for favored constituents. Politicians, even those liberal Democrats who favor increased taxes and spending, find it irresistible to use the tax laws to assist constituents of their districts, states, and party. This tends to keep effective tax rates lower than the statutory marginal rates. On the other hand, the Republican antitax rhetoric adds a certain tension, instability, and schizophrenia to U.S. tax policy. Many of the same politicians who voted in June 1998 to “sunset” the income tax also voted that very same month for a host of new tax preferences proposed by the Republican leadership, including education tax credits and preferential treatment for capital gains. This is one expression of the schizophrenia that pervades Republican tax policy—in contrast with the ordinary pathology that informs Democratic tax policy. Democrats seem to believe that it is possible to impose unlimited taxation on profits and wealth without ever affecting economic activity. Neither the Republican nor the Democratic vision makes for very stable or coherent tax policy. Republican antitax sentiment has generally kept the Democrats in check, and vice versa. The downside of Republican antitax ideology is that at specific times it has overwhelmed the tax legislative process. The tax code is a finely tuned instrument for raising large sums of revenue, and in the 1990s the antitax Republicans unjustifiably weakened the capacity of the tax code and bureaucracy 201

The Prospects for U.S. Tax Policy to raise the revenue necessary to operate the federal government. Excessive tax cuts, as well as harassment of the agency charged with collecting the income tax, has undermined the fiscal foundation of the American state. The inability of the Bush administration to include any significant increase in funding for the military in the 2002 budget on account of his proposed $1.6 trillion tax cut is one consequence of favoring tax reduction over government programs. The longterm insolvency of Social Security is another. Over the past quarter of a century, the antitax policies of the Republican party have checked the natural tendency of politicians in Washington to overtax, but without imposing any comparable restraint upon their impulse to spend. This remains true today, notwithstanding predictions of trillion-dollar surpluses. The result is an endemic gap between politically acceptable levels of taxation and the citizenry’s apparently insatiable appetite for public spending. There is one final issue to consider. This study began by asking whether antitax rhetoric made sense for the Republican party as an electoral strategy. The answer would appear to be a qualified “yes”—at least in recent decades. In the aftermath of World War II, Republicans campaigned on antitax themes with only limited success. However, since the election of Ronald Reagan in 1980, they have been much more successful. In the 1990s, the campaign blossomed, and Republicans captured control of both houses of Congress. In the 2000 election, George W. Bush ran on a platform that included a major tax cut—this at a time when even strong congressional advocates of a tax cut were ready to give up the cause. While it is unclear how much the tax-reduction theme helped Bush in the election, he did manage to parlay his support into a winning coalition that enacted his proposed tax cut within only five months of his taking office. So as an electoral strategy, antitax rhetoric seems to have worked fairly well for conservative Republican candidates since 1980. Whether it provides the basis for a successful program for governing is quite another matter. In that respect, the antitax movement has left the fiscal foundation of the government in a weakened state. Antitax Republicans would return the people’s money back to them via tax cuts notwithstanding the government’s own inadequate funding for such important programs as national defense and Social Security. It has weakened the tax collection agency in administering and enforcing the tax laws that Congress itself wrote. It turns tax policy on its head by using relatively minor current surpluses as the justification for a $1.35 trillion tax cut—this notwithstanding actuarial predictions of some $3 to $6 trillion of unfunded liabilities for Social Security out on the horizon. In the end, the antitax ideology of the Republican party of the 1990s undermined and overwhelmed the fiscal conservatism and common sense that used to be a central tenet of the GOP. Notwithstanding all the rhetoric and bluster of antitax Republicans, as well as their success in passing a major tax cut in May 2001, the income tax will not be repealed any time soon. The income tax will withstand their challenge and persist into the twenty-first century, continuing to serve as the primary source of 202

The Prospects for U.S. Tax Policy revenue of the federal government. Likewise, notwithstanding Republican pretensions of having repealed the federal estate tax, this tax also will likely survive beyond its presently scheduled expiration date of December 31, 2009. In forthcoming sessions of Congress, liberals and centrists will press to resurrect some version of the tax—most likely, reduced to a form closer to what it originally was: an impost on the super-rich. The revenue collected from the estate tax is just too much for the government to forego, and the ideological attachment to the wealth tax is too strong and too deeply entrenched among Democrats to allow for full repeal. Just as legislation to “reform” the federal income tax (meaning, reduce tax rates) has always been a much more likely legislative outcome than ripping it out by roots, so too is a “reformed” estate tax a more likely outcome than repeal. In the future, the partisan policymakers in Congress will undoubtedly continue to enact tax legislation that expresses all the worst features of the tax legislation enacted in the 1980s and 1990s. Future omnibus tax legislation will include provisions that raise revenue while simultaneously enacting other provisions that give tax preferences to powerful economic interests for no justifiable reason. Some tax preferences will be targeted at distinct and separate economic or political interests in the home district of powerful members of Congress; others will implement broad national public policies. Democrats will oppose Republican provisions, and vice versa. Democratic legislation will include some provisions for Republicans, and Republicans will include provisions for the Democratic opposition. That is the nature of contemporary tax legislation. If deadlock was the result of highly partisan tax policy, we probably could live perfectly well with that. At least, we would have a fairly stable body of tax laws. However, one side or the other periodically seizes control of the legislative process and generates a major tax bill. Thereafter, subsequent elections change the status quo, resulting in legislative efforts to reverse those tax policies. The result is erratic, incoherent, and unprincipled tax policy. In 1993, liberal Democrats had their chance to abuse the tax code, and in 2001 the conservative antitax Republicans had theirs. Future Congresses will undoubtedly provide more examples. There is no silver lining here and no end in sight.

203

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Appendix 1: Charts

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CHART 1: FISCAL YEAR 2000 Actual Federal Receipts by Source (all figures $ in billions; $2,025 total revenue)

Payroll Tax $612 32%

Other (excise, customs, etc.) $132 7%

Gift & Estate Tax $29 1%

Corporate Income Tax $207 10%

Individual Income Tax $1,004 50%

Source: Congressional Budget Office, Budget & Economic Outlook: Fiscal Years 2000–2011

207

CHART 2: FEDERAL BUDGET ESTIMATES FY 1995–2001 (in billion of dollars)

800 600 Total Surplus

400 200

On-Budget Surplus

0

1995

2000

2005

2010

-200 -400

Source: CBO Budget and Economic Outlook: Update August 2001

208

CHART 3: FEDERAL BUDGET ESTIMATES FY 1995–2012 (in billions of dollars)

800 600 400

Total Surplus

200 On-Budget Surplus

0

1995

2000

2005

2010

-200 -400 Source: CBO Budget and Economic Outlook: January 2002

209

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Appendix 2: Tables

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Table 1: Aggregate Federal Receipts by Source, 1890–2000 (nominal dollars) [in billions of dollars]

Year 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 1971 1970 1969

Individual income tax 1,004.5 879.5 828.6 737.5 656.4 590.2 543.1 509.7 476.0 467.8 466.9 445.7 401.2 392.6 349.0 334.5 298.4 288.9 297.7 285.9 244.1 217.8 181.0 157.6 131.6 122.4 119.0 103.2 94.7 86.2 90.4 87.2

Payroll tax

Corporate income tax

Excise taxes

Other receipts

652.9 611.8 571.8 539.4 509.4 484.5 461.5 428.3 413.7 396.0 380.0 359.4 334.3 303.3 283.9 265.2 239.4 209.0 201.5 182.7 157.8 138.9 121.0 106.5 90.8 84.5 75.1 63.1 52.6 47.3 44.4 39.0

207.3 184.7 188.7 182.3 171.8 157.0 140.4 117.5 100.3 98.1 93.5 103.3 94.5 83.9 63.1 61.1 56.9 37.0 49.2 61.1 64.6 65.7 60.0 54.9 41.4 40.6 38.6 36.2 32.2 26.8 32.8 36.7

68.9 70.4 57.7 56.9 54.0 57.5 55.2 48.1 45.6 42.4 35.3 34.4 35.2 32.5 32.9 36.0 37.4 35.3 36.3 40.8 24.3 18.7 18.4 17.5 17.0 16.6 16.8 16.3 15.5 16.6 15.7 15.2

91.7 81.0 75.1 63.2 61.4 62.7 57.6 50.0 55.0 49.9 55.5 47.9 43.7 41.9 40.2 37.2 34.4 30.3 33.0 28.7 26.3 22.1 19.3 19.0 17.3 15.0 13.7 12.0 12.4 10.2 9.5 8.7

Continued on next page

213

Table 1, Continued

Year

Individual income tax

Payroll tax

Corporate income tax

Excise taxes

Other receipts

1968 1967 1966 1965 1964 1963 1962 1961 1960 1959 1958 1957 1956 1955 1954 1953 1952 1951 1950 1949 1948 1947 1946 1945 1944 1943 1942 1941 1940 1939 1938 1937 1936 1935 1934 1933 1932 1931 1930 1929

68.7 61.5 55.4 48.8 48.7 47.6 45.6 41.3 40.7 36.7 34.7 35.6 32.2 28.7 29.5 29.8 27.9 21.6 15.8 15.6 19.3 17.9 16.1 18.4 19.7 6.5 3.3 1.3 0.9 1.0 1.3 1.1 0.7 0.5 0.4 0.4 0.4 0.8 1.1 1.1

33.9 32.6 25.5 22.2 22.0 19.8 17.0 16.4 14.7 11.7 11.2 10.0 9.3 7.9 7.2 6.8 6.4 5.7 4.3 3.8 3.8 3.4 3.1 3.5 3.5 3.0 2.5 1.9 1.8 1.6 1.5 0.6 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0

28.7 34.0 30.1 25.5 23.5 21.6 20.5 21.0 21.5 17.3 20.1 21.2 20.9 17.9 21.1 21.2 21.2 14.1 10.4 11.2 9.7 8.6 11.9 16.0 14.8 9.6 4.7 2.1 1.2 1.1 1.3 1.0 0.7 0.5 0.4 0.4 0.6 1.0 1.3 1.2

14.1 13.7 13.1 14.6 13.7 13.2 12.5 11.9 11.7 10.6 10.6 10.5 9.9 9.1 9.9 9.9 8.9 8.6 7.6 7.5 7.4 7.2 7.0 6.3 4.8 4.1 3.4 2.6 2.0 1.9 1.9 1.9 1.6 1.4 1.4 0.8 0.5 0.5 0.6 0.5

7.6 7.0 6.7 5.8 4.7 4.4 4.0 3.8 3.9 2.9 3.0 2.7 2.3 1.9 1.9 1.9 1.7 1.6 1.4 1.4 1.5 1.3 1.2 1.1 1.0 0.8 0.8 0.8 0.7 0.7 0.8 0.8 0.8 1.1 0.8 0.0 0.0 0.0 0.1 0.1

214

1928 1927 1926 1925 1924 1923 1922 1921 1920 1919 1918 1917 1916 1915 1914 1913 1912 1911 1910 1909 1908 1907 1906 1905 1904 1903 1902 1901 1900 1899 1898 1897 1896 1895 1894 1893 1892 1891 1890

0.9 0.9 0.9 0.8 0.8 0.9 0.7 1.1 1.3 1.1 0.8 0.2 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

1.3 1.3 1.1 0.9 0.9 0.0 0.0 0.0 0.0 0.0 0.0 0.2 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.5 0.5 0.6 0.5 0.7 0.6 0.6 0.7 0.8 0.8 0.6 0.4 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.2 0.3 0.3 0.2 0.2 0.2 0.2 0.3 0.3 0.3 0.3 0.2 0.1 0.1 0.1 0.1 0.2 0.2 0.1 0.1

0.1 0.2 0.3 0.3 0.4 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Source: Joint Committee on Taxation; Office of Management and Budget, Historical Tables, Budget of the United States Government, Fiscal Year 1996; and Census Bureau, Department of Commerce, Historical Statistics of the United States, Colonial Times to Present.

215

Table 2: Federal Receipts by Source, as a Percentage of Total Revenues, 1890– 2000

Year

Individual income tax

Payroll taxes

Corporate income tax

Excise taxes

Other receipts

2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 1971 1970 1969 1968

49.60 48.13 46.70 45.18 43.66 43.66 43.18 44.18 43.65 44.37 45.27 44.99 44.14 45.96 45.37 45.57 44.78 48.11 48.20 47.71 47.20 47.02 45.30 44.33 44.15 43.85 45.19 44.73 45.70 46.08 46.89 46.69 44.93

32.24 33.48 33.21 34.15 35.06 35.84 36.69 37.13 37.94 37.56 36.85 36.28 36.78 35.51 36.91 36.12 35.92 34.80 32.62 30.49 30.52 29.99 30.27 29.95 30.45 30.29 28.52 27.35 25.36 25.29 23.01 20.88 22.18

10.24 10.11 10.96 11.54 11.82 11.61 11.16 10.19 9.20 9.30 9.07 10.43 10.40 9.83 8.21 8.33 8.54 6.16 7.96 10.20 12.49 14.18 15.00 15.44 13.89 14.55 14.67 15.66 15.52 14.31 17.03 19.63 18.74

3.40 3.85 3.35 3.60 3.72 4.25 4.39 4.17 4.18 4.02 3.43 3.47 3.88 3.80 4.28 4.90 5.61 5.88 5.88 6.81 4.70 4.05 4.60 4.94 5.69 5.93 6.40 7.05 7.47 8.88 8.15 8.15 9.20

4.53 4.43 4.36 4.00 4.23 4.64 4.58 4.33 5.04 4.74 5.39 4.84 4.81 4.90 5.22 5.07 5.16 5.05 5.34 4.78 5.09 4.77 4.82 5.35 5.81 5.37 5.22 5.21 5.96 5.44 4.93 4.66 4.96

216

1967 1966 1965 1964 1963 1962 1961 1960 1959 1958 1957 1956 1955 1954 1953 1952 1951 1950 1949 1948 1947 1946 1945 1944 1943 1942 1941 1940 1939 1938 1937 1936 1935 1934 1933 1932 1931 1930 1929 1928 1927 1926 1925 1924 1923 1922

41.34 42.38 41.77 43.24 44.66 45.72 43.80 44.02 46.33 43.60 44.53 43.15 43.92 42.38 42.83 42.22 41.88 39.94 39.46 46.47 46.57 40.97 40.68 45.04 27.10 22.30 15.08 13.62 16.35 19.05 20.27 17.18 14.60 14.21 21.79 27.41 34.35 37.73 37.29 31.64 31.82 30.99 32.70 30.22 32.84 22.49

21.92 19.53 19.04 19.50 18.58 17.10 17.42 15.87 14.79 14.11 12.50 12.50 12.01 10.34 9.80 9.74 10.99 11.00 9.59 9.03 8.89 7.93 7.64 7.94 12.68 16.76 22.27 27.26 25.31 22.83 10.77 1.33 0.86 1.02 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

22.83 22.99 21.80 20.86 20.25 20.59 22.20 23.24 21.84 25.21 26.46 27.99 27.29 30.27 30.51 32.08 27.32 26.49 28.40 23.29 22.37 30.24 35.40 33.92 39.82 32.25 24.38 18.28 17.90 19.06 19.27 18.33 14.66 12.32 24.32 40.44 42.26 41.55 42.06 46.29 45.64 38.61 35.45 32.76 0.00 0.00

9.22 9.98 12.47 12.19 12.38 12.57 12.57 12.62 13.35 13.36 13.17 13.31 13.95 14.27 14.19 13.38 16.75 19.14 19.03 17.70 18.72 17.81 13.87 10.88 17.07 23.23 29.29 30.19 29.72 27.60 34.82 41.58 39.87 45.82 51.79 29.14 21.42 18.59 18.37 17.23 16.82 20.13 21.01 23.86 23.84 18.55

4.69 5.13 4.92 4.20 4.12 4.02 4.02 4.24 3.69 3.72 3.34 3.04 2.83 2.73 2.67 2.58 3.06 3.43 3.52 3.51 3.46 3.06 2.40 2.22 3.33 5.47 8.98 10.64 10.72 11.46 14.87 21.59 30.01 26.63 2.10 3.02 1.98 2.14 2.28 4.84 5.72 10.26 10.84 13.16 0.00 0.00

Continued on next page

217

Table 2, Continued

Year

Individual income tax

Payroll taxes

Corporate income tax

Excise taxes

Other receipts

1921 1920 1919 1918 1917 1916 1915 1914 1913 1912 1911 1910 1909 1908 1907 1906 1905 1904 1903 1902 1901 1900 1899 1898 1897 1896 1895 1894 1893 1892 1891 1890

23.39 23.48 29.30 21.49 22.25 13.26 9.86 7.37 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.00 0.00 0.00 0.00 25.59 11.11 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

14.91 14.94 21.74 17.22 47.96 66.28 78.85 80.79 89.53 90.37 88.85 92.07 99.59 99.21 99.26 99.60 99.15 98.71 96.54 95.22 95.77 96.27 97.07 98.83 99.32 98.64 99.30 98.64 98.76 98.70 99.32 99.30

0.00 0.00 0.00 0.00 4.20 9.36 0.00 0.00 10.47 9.63 11.15 7.93 0.41 0.79 0.74 0.40 0.85 1.29 3.46 4.78 4.23 3.73 2.93 1.17 0.68 1.36 0.70 1.36 1.24 1.30 0.68 0.70

Source: Joint Committee on Taxation; Office of Management and Budget, Historical Tables, Budget of the United States Government, Fiscal Year 1996; and Census Bureau, Department of Commerce, Historical Statistics of the United States, Colonial Times to Present.

218

Table 3: Federal Receipts by Source, as a Percentage of GDP, 1934 –2000

Year

Total receipts

Individual income tax

Payroll taxes

Corporate income tax

Excise taxes

Other receipts

2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 1971 1970 1969

20.50 20.00 20.00 19.20 18.70 18.50 18.96 18.43 18.42 18.57 18.81 19.15 18.90 19.18 18.23 18.50 18.04 18.11 19.79 20.22 19.56 19.07 18.54 18.55 17.70 18.49 18.75 18.12 18.06 17.81 19.57 20.19

10.20 9.60 9.60 9.00 8.50 8.10 8.19 8.14 8.04 8.24 8.52 8.62 8.34 8.82 8.27 8.43 8.08 8.71 9.54 9.65 9.23 8.97 8.40 8.22 7.81 8.11 8.47 8.10 8.25 8.21 9.18 9.43

6.60 6.70 6.60 6.60 6.60 6.60 6.96 6.84 6.99 6.98 6.93 6.95 6.95 6.81 6.73 6.68 6.48 6.30 6.45 6.16 5.97 5.72 5.61 5.55 5.39 5.60 5.35 4.95 4.58 4.50 4.50 4.21

2.10 2.00 2.20 2.20 2.20 2.10 2.12 1.88 1.69 1.73 1.71 2.00 1.97 1.88 1.50 1.54 1.54 1.12 1.58 2.06 2.44 2.70 2.78 2.86 2.46 2.69 2.75 2.84 2.80 2.55 3.33 3.96

0.70 0.80 0.70 0.70 0.70 0.80 0.83 0.77 0.77 0.75 0.64 0.66 0.73 0.73 0.78 0.91 1.01 1.06 1.16 1.38 0.92 0.77 0.85 0.92 1.01 1.10 1.20 1.28 1.35 1.58 1.59 1.64

0.90 0.90 0.90 0.70 0.70 0.90 0.87 0.80 0.93 0.88 1.01 0.93 0.91 0.94 0.95 0.94 0.93 0.91 1.06 0.97 1.00 0.91 0.89 0.99 1.03 0.99 0.98 0.94 1.08 0.97 0.96 0.94

Continued on next page

219

Table 3, Continued

Year

Total receipts

Individual income tax

Payroll taxes

Corporate income tax

Excise taxes

Other receipts

1968 1967 1966 1965 1964 1963 1962 1961 1960 1959 1958 1957 1956 1955 1954 1953 1952 1951 1950 1949 1948 1947 1946 1945 1944 1943 1942 1941 1940 1939 1938 1937 1936 1935 1934

18.06 18.76 17.79 17.41 18.01 18.23 17.95 18.26 18.33 16.50 17.77 18.25 17.92 17.01 18.94 19.13 19.43 16.46 14.84 15.00 16.85 17.28 18.49 21.30 21.69 13.68 10.32 7.74 6.86 7.17 7.69 6.21 5.06 5.25 4.89

8.11 7.76 7.54 7.27 7.79 8.14 8.21 8.00 8.07 7.65 7.75 8.13 7.73 7.47 8.03 8.20 8.20 6.90 5.93 5.92 7.83 8.05 7.58 8.67 9.77 3.71 2.30 1.17 0.94 1.17 1.46 1.26 0.87 0.77 0.70

4.00 4.11 3.47 3.31 3.51 3.39 3.07 3.18 2.91 2.44 2.51 2.28 2.24 2.04 1.96 1.87 1.89 1.81 1.63 1.44 1.52 1.54 1.47 1.63 1.72 1.74 1.73 1.72 1.87 1.81 1.76 0.67 0.07 0.05 0.05

3.38 4.28 4.09 3.79 3.76 3.69 3.70 4.05 4.26 3.60 4.48 4.83 5.02 4.64 5.73 5.84 6.23 4.50 3.93 4.26 3.92 3.86 5.59 7.54 7.36 5.45 3.33 1.89 1.25 1.28 1.47 1.20 0.93 0.77 0.60

1.66 1.73 1.78 2.17 2.20 2.26 2.26 2.29 2.31 2.20 2.37 2.40 2.39 2.37 2.70 2.71 2.60 2.76 2.84 2.86 2.98 3.24 3.29 2.96 2.36 2.34 2.40 2.27 2.07 2.13 2.12 2.16 2.10 2.09 2.24

0.89 0.88 0.91 0.86 0.76 0.75 0.72 0.73 0.78 0.61 0.66 0.61 0.55 0.48 0.52 0.51 0.50 0.50 0.51 0.53 0.59 0.60 0.57 0.51 0.48 0.46 0.56 0.70 0.73 0.77 0.88 0.92 1.09 1.58 1.30

Source: Joint Committee on Taxation; Office of Management and Budget, Historical Tables, Budget of the United States Government, Fiscal Year 1996; and Census Bureau, Department of Commerce, Historical Statistics of the United States, Colonial Times to Present.

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Table 4: History of Federal Individual Income Tax Rates and Top Brackets, 1913–2006

Year 20062005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1989–1990 1988 1987 1986 1985 1984 1983 1982 1981 1979–1980 1972–1978 1971 1970 1969 1968

Top Tax Rates1

Top Bracket on Taxable Income Over 297,3508 297,3508 297,3508 297,3508 297,3508 297,350 288,350 283,150 278,450 271,050 263,750 256,500 250,000 250,000 86,500 82,150 149,250 149,250 90,000 171,580 149,250 159,000 106,000 106,000 212,000 212,000 200,000 200,000 200,000 200,000 200,000

35.00 37.60 37.60 38.60 38.60 38.60 39.60 39.60 39.60 39.60 39.60 39.60 39.60 39.60 31.00 31.00 28.004,7 28.004,7 38.504 50.004 50.004 50.024 50.004 50.004 69.124,5,6 70.004,5 70.004,6 70.005,5 71.753,4 77.003 75.253

Continued on next page

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Table 4, Continued

Year 1965–1967 1964 1954 –1963 1952–1953 1951 1950 1948–1949 1946–1947 1944 –1945 1942–1943 1941 1940 1936–1939 1934 –1935 1932–1933 1930–1931 1929 1925–1928 1924 1923 1922 1921 1919–1920 1918 1917 1916 1913–1915

Top Tax Rates1 70.00 77.00 91.002 92.002 91.002 91.002 82.132 86.452 94.002 88.00 81.00 81.10 79.00 63.00 63.00 25.00 24.00 25.00 46.00 56.00 56.00 73.00 73.00 77.00 67.00 15.00 7.00

Top Bracket on Taxable Income Over 200,000 400,000 400,000 400,000 400,000 400,000 400,000 200,000 200,000 200,000 5,000,000 5,000,000 5,000,000 1,000,000 1,000,000 100,000 100,000 100,000 500,000 200,000 200,000 1,000,000 1,000,000 1,000,000 2,000,000 2,000,000 500,000

1. Taxable income excludes zero-bracket amount from 1977-1986. Rates shown apply only to married persons filing joint beginning in 1948. From 1922–1986 lower rates applied to long-term capital gains. 2. Subject to the following maximum effective rate limitations (year and maximum effective rate): 1944 –1945: 90%; 1946–1947: 85.5%; 1948–1949: 77%; 1950: 87%; 1951: 87.2%; 1952–1953: 88%; and 1954 –1963: 87%. 3. Includes surcharge of 7.5% in 1968, 10% in 1969, and 2.5% in 1970. 4. Does not include add-on minimum tax on preference items or alternative minimum tax. 5. Earned income was subject to maximum marginal rates of 60% in 1971 and 50% from 1972–1981.

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6. After tax credit of 1.25% against regular tax. 7. Excludes the effects of the phaseout of the 15% bracket and personal exemptions. 8. Will be adjusted annually Source: Joint Committee on Taxation; Office of Management and Budget, Historical Tables, Budget of the United States Government, Fiscal Year 1996; and Census Bureau, Department of Commerce, Historical Statistics of the United States, Colonial Times to Present.

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Table 5: Maximum Estate Tax Rates, 1916–2010

Basic Tax Year 1916 1917 1918–23 1924 –25 1926–31 1932–33 1934 1935–39 19401 1941 1942–53 1954 –76 19772 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987–953,4 1996 1997 1998 1999 2000 2001 2002 2003 2004

Supplemental Tax

Exemption

Top rate

Top bracket

50,000 50,000 50,000 50,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 60,000 120,000 134,000 147,000 161,000 175,000 225,000 275,000 325,000 400,000 500,000 600,000 600,000 600,000 625,000 650,000 675,000 675,000 1,000,000 1,000,000 1,500,000

10 25 25 40 20 20 20 20 20 20 20 77 70 70 70 70 70 65 60 55 55 55 55 55 55 55 55 55 55 50 49 48

5,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 5,000,000 5,000,000 5,000,000 5,000,000 5,000,000 4,000,000 3,500,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 2,500,000 2,000,000 2,000,000

224

Exemption

Top rate

Top bracket

50,000 50,000 40,000 40,000 40,000 60,000

45 60 70 70 77 77

10,000,000 10,000,000 50,000,000 50,000,000 10,000,000 10,000,000

2005 2006 2007 2008 2009 2010

1,500,000 2,000,000 2,000,000 2,000,000 3,500,000 0

47 46 45 45 45 0

2,000,000 2,000,000 1,500,000 1,500,000 1,500,000 N/A

1. 10% war surtax added 2. Unified credit replaces exemption 3. Tax rate was to be reduced to 50% on amounts beginning in 1988, but was postponed until 1992, then repealed retroactively in 1993 and set permanently to the 1987 levels. 4. Graduated rates and unified credits phased out for estates over $10,000,000. Source: Internal Revenue Service

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Notes Introduction 1. References to the Republican party as the Grand Old Party (or GOP) date back to the 1870s and 1880s. The name “Grand Old Party” first appeared in the Cincinnati Commercial in 1876, and the abbreviation “G.O.P.” was first used in a story in the New York Herald on 15 October 1884. 2. In virtually every poll conducted in recent years, voters (and Americans generally) simply do not rate tax cuts as a primary goal. Spending for education, Social Security, and health care usually beat out tax cuts. For a summary of recent polling trends, see Bruce Bartlett, “The Trouble with Tax Cuts,” Policy Review 98 (December 1999/January 2000): 3. 3. Sheldon D. Pollack, The Failure of U.S. Tax Policy: Revenue and Politics (University Park: Penn State Press, 1996). 4. David Brooks, “Permanent Defense: Republicans and Their Discontent,” The Weekly Standard, 6 August 2001: 28. 5. The Bush energy tax policy is discussed in Martin A. Sullivan, “Bush’s Energy Plan: Putting New Spark in Old Proposals,” Tax Notes, 28 May 2001: 1493. 6. Quoted in Wall Street Journal, (hereafter WSJ) 2 February 2001: A10. 7. E. E. Schattschneider, Party Government (New York: Holt, Rinehart and Winston, 1942), 35. 8. Joint Economic Committee, “New IRS Data on Income Tax Shares,” Press Release (14 January 2002). These figures for 1998 were released by the Internal Revenue Service and are found in the IRS Statistics of Income Bulletin. See David Campbell and Michael Parisi, “Individual Income Tax Rates and Shares, 1998,” SOI Bulletin, Spring 2001, Table 7. 9. An excellent profile of the rich (the top 20 percent) and the super-rich (the top 1 percent) is found in Edward N. Wolff, “Who Are the Rich? A Demographic Profile of High-Income and High-Wealth Americans,” in Does Atlas Shrug? The Economic Consequences of Taxing the Rich, ed. Joel B. Slemrod (Cambridge, Mass.: Harvard University Press and Russell Sage Foundation, 2000), 74 –113. The essays in this volume collectively provide a comprehensive picture of the status of the rich in the United States. For a summary of these findings, see the introductory essay, Joel B. Slemrod, “The Economics of Taxing the Rich” in ibid., 3–28. 227

Notes to Pages 7–9 10. By way of illustration, the top 1 percent owned 32.6 percent of total net wealth and 42.9 percent of financial wealth in 1983, while they owned 35.9 percent and 45.6 percent of the same categories in 1992. Overall, the share of net wealth owned by the top 5 percent increased, while the share owned by everyone else declined during this period. See Wolff, “Who Are the Rich?,” 77. Studies show that the concentration of wealth in the hands of the rich and super-rich continued throughout the rest of the 1990s. See Congressional Budget Office, Historical Effective Tax Rates, 1979–1997: Preliminary Edition (Washington, D.C.: Government Printing Office, (GOP) May 2001), Introduction: “The share of pretax income going to the highest fifth of households climbed from 46 percent in 1979 to 53 percent in 1997, while the share going to the lowest three quintiles dropped from 32 percent to 27 percent. At the very top of the distribution, the highest 1 percent of households took home 16 percent of total pretax income in 1997, up from 9 percent in 1979.” See also Tom Petska and Mike Strudler, “The Distribution of Individual Income and Taxes: A New Look at an Old Issue,” SOI Research Paper, Statistics of Income Division, Internal Revenue Service (10 March 2000). 11. The group, known as “Responsible Wealth,” was organized by Bill Gates Sr. They ran an advertisement in major national newspapers on February 18 urging lawmakers to “fix,” rather than eliminate the estate tax. Those who signed the ad include Gates, George Soros, Steven Rockefeller David Rockefeller, Jr., Frank Roosevelt, and Paul Newman. While billionaire Warren Buffett did not sign the ad, he was publicly quoted as supporting their goals. For an account of the campaign by the super-rich to keep the estate tax, see Paul Gigot, “Fat-Cat Cavalry Rides In to Rescue High Taxes,” WSJ, 16 February 2001: A10. 12. This is the interesting thesis of a recent study that argues that politicians do not “pander” to public opinion to the extent often assumed. Republican antitax policies in the mid-1990s are given as a prime example of such indifference to polls and public opinion. See Lawrence R. Jacobs and Robert Y. Shapiro, Politicians Don’t Pander: Political Manipulation and the Loss of Democratic Responsiveness (Chicago: University of Chicago Press, 2000). 13. Political scientists Morris Fiorina and David Mayhew argue that the very same politicians who create government programs and the agencies to run them will rail against the “bureaucracy” in their electoral campaigns in an effort to appeal to the anti-Washington mentality of the electorate. See Morris P. Fiorina, Congress: Keystone of the Washington Establishment (New Haven: Yale University Press, 1977), and David R. Mayhew, Congress: The Electoral Connection (New Haven: Yale University Press, 1974), 16–17. Mayhew argues that the behavior of members of Congress can best be explained as “single-minded reelection seeking.” 14. The main theme of my book, The Failure of U.S. Tax Policy, is that policymakers use the tax laws for diverse and often conflicting purposes. Among these are raising revenue, as a macroeconomic tool for directing the national 228

Notes to Pages 9–22 economy, as a bipartisan tool for cultivating favor with constituents, and as a partisan tool for implementing party objectives. The use of the tax laws for these conflicting purposes leads to the undermining of the integrity and coherence of the income tax, and increases the gross complexity that already plagues the tax laws. See Pollack, Failure, 9–25. 15. Over the years, there have been numerous legislative proposals introduced by Republican congressmen to repeal the Sixteenth Amendment, which declares: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” Among the many Republicans who have repeatedly introduced resolutions to repeal the Sixteenth Amendment are Bill Archer (Texas), former chairman of Ways and Means; William M. Thomas (California), current chairman of Ways and Means; Majority Whip Tom DeLay (Texas); Ron Paul (Texas); and Sam Johnson (Texas). Gadfly Democrat James A. Traficant Jr. of Ohio has often joined Republican efforts to repeal the Internal Revenue Code and the Sixteenth Amendment. 16. By only the narrowest of margins, the balanced budget constitutional amendment failed to pass the Senate in 1995 and 1997. The House twice approved the amendment. 1

The Origins of Republican Tax Policy

1. The term “Old Guard” had its origin at the 1880 Republican convention when it was used in refer to the supporters of President Ulysses S. Grant. In subsequent years, the term was used generally to refer to staunch economic conservatives in the GOP—also referred to as the Right Wing. In the postwar era, the Right Wing was traditionally associated with anticommunism and free market economics. 2. The best history of the early years of the Republican party is William E. Gienapp, The Origins of the Republican Party, 1852–1856 (New York: Cambridge University Press, 1987). A general overview of the party is George H. Mayer, The Republican Party, 1854 –1966 (New York: Oxford University Press, 1967). The best account of the eclectic factions that came together in the Republican party, especially concerning the slavery question, remains Eric Foner, Free Soil, Free Labor, Free Men: The Ideology of the Republican Party Before the Civil War (New York: Oxford University Press, 1970). 3. Article I, Section 2 of the Constitution provides that “representatives and direct Taxes shall be apportioned among the several States.” Article I, Section 9 simply states: “No Capitation, or other direct, tax shall be laid, unless in Proportion to the Census.” 4. New York Times, (NYT) 8 January 1862, 4. 5. Act of July 1, 1862, 12 Stat. 432, 483. Legislative history is found at Congressional Globe, 37th Cong., 2nd Sess., (1862) 1534. 229

Notes to Pages 23–25 6. Cong. Globe, 37th Cong., 2d sess. (1862) 1196. 7. For an account of the relationship between state, society, and the new Republican party during the Civil War, see Richard F. Bensel, Yankee Leviathan: The Origins of Central State Authority in America, 1859–1877 (Cambridge, Eng.: Cambridge University Press, 1990). According to Bensel, “As a consequence of secession and the Civil War, the American state was captured by the Republican party. During the war and the decade immediately following, the American state and the Republican party were more or less synonymous and this near identity was accompanied by an instrumentalist implementation of a broad [Republican] political agenda. . . .” 8. The first commissioner of Internal Revenue, George S. Boutwell of Massachusetts, had recommended that the tax rate rise to 5.5 percent on annual income in excess of $20,000. Report of the Commissioner of Internal Revenue for the Year ending June 30, 1863 (Washington, D.C., 1864), 183–84. An excellent account of the Civil War income tax and the development of the Bureau of Internal Revenue (precursor of the Internal Revenue Service) is Joe Thorndike, “An Army of Officials: The Civil War Bureau of Internal Revenue,” Tax Notes, 24 December 2001: 1739. 9. Cong. Globe, 38th Cong., 1st sess. (1864) 1876. 10. Ibid., 1940. 11. Figures cited in Sidney Ratner, American Taxation: Its History as a Social Force in Democracy (New York: W.W. Norton, 1942), 141. 12. W. Elliot Brownlee, “Historical Perspective on U.S. Tax Policy Toward the Rich,” in Does Atlas Shrug? The Economic Consequences of Taxing the Rich, ed. Joel B. Slemrod (Cambridge, Mass.: Harvard University Press and Russell Sage Foundation, 2000), 34 –35. Robert Stanley has concluded that approximately 1.3 percent of the American people paid the tax. Robert Stanley, Dimensions of Law in the Service of Order: Origins of the Federal Income Tax, 1861– 1913 (New York: Oxford University Press, 1993), 39– 40 and 263–64. 13. Act of July 15, 1870, 16 Stat. 256. 14. Stanley, Dimensions of Law, viii. 15. This is a central theme of Theda Skocpol, Protecting Soldiers and Mothers (Cambridge, Mass.: Harvard University Press, 1992). In 1900, some 45 percent of the receipts of the federal government was still dedicated to Civil War pensions. 16. The best history of the GOP during the post–Civil War decades is Robert D. Marcus, Grand Old Party: Political Structure in the Gilded Age, 1880– 1896 (New York: Oxford University Press, 1971). 17. In 1888, Cleveland actually won a slight plurality of the popular vote (48.6 percent to 47.7 percent), but lost the election to Benjamin Harrison in the electoral college (233 to 168). 18. The classic account of the Democratic party in the South is V.O. Key, Southern Politics in State and Nation (New York: Knopf, 1949). 230

Notes to Pages 26–29 19. Congressional Record, 53d Cong., 2d sess. (22 June 1894), 26, pt. 7, 6695 (Senator John Sherman of Ohio). For an explanation of why Sherman, who had supported the Civil War income tax, was so adamant in his opposition to Bryan’s proposal for a progressive income tax, see Stanley, Dimensions of Law, 96–99. 20. Pollock v. Farmer’s Loan & Trust Co., 157 U.S. 429c (1895); 158 U.S. 601 (1895) (rehearing). 21. An interesting summary and provocative interpretation of the constitutional issues raised in the Pollock case is found in Bruce Ackerman, “Taxation and the Constitution,” Columbia Law Review 99 (1999): 1. Ackerman’s persuasive argument is that in their several references to “direct” taxation in the Constitution of 1787, the Founders did not have a clear sense of any economic or theoretical distinction that they were relying upon, but were rather laying the foundation for a political compromise over the issue of slavery. In that compromise, the Southern states would be permitted to count three-fifths of its slaves for purposes of representation in the House if they were willing to pay threefifths of the taxes attributable to that population. Up until Pollock, the Supreme Court had been prudent enough to narrowly interpret the phrase “direct tax” in order to avoid unraveling this political compromise. After the ratification of the Thirteenth, Fourteenth, and Fifteenth Amendments, the whole issue was rendered moot, and the Court never should have reopened the whole can of worms. 22. Taft once remarked to an aide, Major Archie Butt, that: “Nothing has ever injured the prestige of the Supreme Court more” than the Pollock decision. Quoted in Archibald W. Butt, Taft and Roosevelt: The Intimate Letters of Archie Butt (Garden City, N.Y.: Doubleday, Doran & Co., 1930), 134. 23. In a speech before Congress, Taft supported Aldrich’s constitutional amendment: “The decision of the Supreme Court in the income-tax cases deprived the National Government of a power which, by reason of previous decisions of the court, it was generally supposed that Government had. It is undoubtedly a power the National Government ought to have.” President William Howard Taft to the Senate and House of Representatives, 16 June 1909, in Messages and Papers of the Presidents (Washington, D.C.: Bureau of National Literature, 1912), 7770. 24. The Sixteenth Amendment was ultimately ratified by 42 of the 48 states then in the Union. 25. The best account of state-building in the Progressive era is Stephen Skowronek, Building a New American State: The Expansion of National Administrative Capacities, 1877–1920 (New York: Cambridge University Press, 1982). 26. For example, Old Guard Republicans from the Northeast, led in the Senate by Nelson Aldrich, chairman of the Finance Committee, attempted to kill or water down railroad regulation and block passage of the Hepburn Act in 1906. 27. Cong. Rec., 63d Cong., 1st sess. (6 May 1913), vol. 50, pt. 2: 1252. 28. Ibid., (28 August 1913), vol. 50, pt. 4: 3840. 29. Brownlee, “Historical Perspective,” 41. 231

Notes to Pages 30–39 30. Pub. L. No. 65–50, 40 Stat. 300. A concise account of the politics of the Revenue Act of 1917 is found in Jerold L. Waltman, Political Origins of the U.S. Income Tax (Jackson: University Press of Mississippi, 1985), 42–54. 31. W. Elliot Brownlee, Federal Taxation in America: A Short History (New York: Cambridge University Press, 1996), 49. 32. Brushaber v. Union Pac. R.R. Co., 240 U.S. 1 (1916). 33. For an account of the development of the new relationship between the GOP and business with respect to campaign finance, see Skowronek, Building a New American State, 74 –78. 34. Warren G. Harding, “Special Address to Congress,” in Messages and Papers of the Presidents (New York: Bureau of National Literature, n.d.), 8937. 35. Mellon’s philosophy on taxation was presented in his popular book, Taxation: The People’s Business (New York: Macmillan, 1924). 2

Forever a Minority Party?

1. A new biography of Al Smith provides insights into his background and politics. See Robert A. Slayton, Empire Statesman: The Rise and Redemption of Al Smith (New York: Free Press, 2001). 2. By 1934, revenue from the corporate and individual income taxes declined to less than one-third of total federal revenues, down from 67 percent as late as 1931. Figures from U.S. Census, Historical Statistics. 3. Henry C. Simons, Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy (Chicago: University of Chicago Press, 1938), 219. 4. Roosevelt’s tax proposals are found in “A Message to the Congress on Tax Revisions,” in The Public Papers and Addresses of Franklin D. Roosevelt, vol. 4 (New York: Random House, 1938), 270. 5. Political scientist Theodore Lowi outlines the different politics generated by different types of public policies—i.e., those that are distributive, regulatory, and redistributive. Theodore J. Lowi, “American Business, Public Policy, Case Studies, and Political Theory,” World Pol. 16 (1964): 677. Lowi further developed his analysis in “Four Systems of Policy, Politics, and Choice,” Public Admininstration Review 33 (1972): 298. Using a steeply progressive income tax to force the rich to pay for benefits earmarked for the poor would be a purely redistributive policy. 6. Again, the reference is to Lowi, who laments the rise of modern “interest group” liberalism in The End of Liberalism (New York: W.W. Norton, 1969). This kind of interest group politics was already observed during the 1920s and 1930s and associated with policymaking over the tariff. See E. E. Schattschneider, Politics, Pressures, and the Tariff (New York: Prentice-Hall, 1935). 7. This is the general theme of Mark H. Leff, The Limits of Symbolic Reform: The New Deal and Taxation, 1933–1939 (New York: Cambridge Univer-

232

Notes to Pages 39– 43 sity Press, 1984), 145. Leff ’s insightful analysis provides the best and most comprehensive account of New Deal tax policies. According to Leff: “The Revenue Act of 1935 reaped a political whirlwind, but it generated only a financial breeze.” 8. William E. Leuchtenburg, Franklin D. Roosevelt and the New Deal, 1932–1940 (New York: Harper & Row, 1963), 117. 9. Clyde P. Weed, The Nemesis of Reform: The Republican Party During the New Deal (New York: Columbia University Press, 1994), 5. Weed gives an interesting account of how Republicans during the New Deal were forced to adopt a new strategy as the minority party. He argues that the Old Guard conservatives held fast to their principles and control of the party machinery. Their intent was to wait out the New Deal, just as they had with the Progressive movement, offering their brand of Republicanism as the alternative when the electorate tired of Roosevelt. It turned out to be a long wait. 10. Ibid. 11. Leff, Limits of Symbolic Reform, 208. 12. Ironically, Landon and the Republicans criticized the Social Security program on grounds similar to those advanced by the left (e.g., the poor were left out of the system, benefits were inadequate, and the payroll tax was regressive). 13. Leuchtenburg, Franklin D. Roosevelt, 196. 14. The theory of critical elections was first suggested by V. O. Key Jr., “A Theory of Critical Elections,” Journal of Politics 17 (1955): 3–7. Later, it was developed and refined by Walter Dean Burnham, Critical Elections and the Mainspring of American Politics (New York: W.W. Norton, 1970). 15. The connection between critical elections and the development of the “party system” is explored in the essays in The American Party Systems: Stages of Political Development, ed. William Nisbet Chambers and Walter Dean Burnham (New York: Oxford University Press, 1967). 16. For account of the emergence of these new patterns of financing the two parties, see Louise Overacker, Presidential Campaign Funds (Boston: Boston University Press, 1947); “Campaign Funds in the Presidential Election of 1936,” APSR 31 (1937): 492. 17. This is the central theme of an important study on the impact of the New Deal on the party system, Sidney M. Milkis, The President and the Parties: The Transformation of the American Party System Since the New Deal (New York: Oxford University Press, 1993). 18. James L. Sundquist, Dynamics of the Party System: Alignment and Realignment of Political Parties in the United States (Washington, D.C.: Brookings Institution Press, 1973), 240– 42. 19. To speed up the collection of badly needed revenue for the war effort, Congress enacted the Current Tax Payment Act of 1943, Pub. L. No. 78–68, 57 Stat. 126. This statute imposed a new obligation on “payers” of compensation

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Notes to Pages 43– 48 (e.g., wages), interest, and dividends, requiring them to withhold a prescribed amount of income tax from the payment itself. 20. See A. L. A. Schechter Poultry Corp. v. United States, 295 U.S. 495 (1935) (the Court struck down regulations that fixed the hours and wages of individuals employed by an intrastate business because the activity being regulated related to interstate commerce only indirectly). 21. See e.g., NLRB v. Jones & Laughlin Steel Corp., 301 U.S. 1 (1937); Wickard v. Filburn, 317 U.S. 111 (1942); United States v. Darby, 312 U.S. 100 (1941). 22. A new study suggests that the transformation of the Supreme Court and its interpretation of the Constitution was not so sudden, as the conventional view holds, but rather began in the 1920s and was not fully resolved until the 1940s. G. Edward White, The Constitution and the New Deal (Cambridge: Harvard University Press, 2001). 23. See David W. Reinhard, The Republican Right Since 1945 (Lexington: University Press of Kentucky, 1983), 18. Reinhard’s is the best account of the Republican Right Wing during the period from 1945–1965. 24. A concise summary of the conflict between Truman and congressional Republicans during the 80th Congress is Anthony Badger, “Republican Rule in the 80th Congress,” in The Republican Takeover of Congress, ed. Dean McSweeney and John E. Owens (New York: St. Martin’s Press, 1998), 165–84. 25. In all, Truman exercised his veto power more than 200 times, mostly with respect to tax and labor legislation. The most famous case was Truman’s veto of the 1947 Taft-Hartley Act, which veto Congress overrode. 26. Republicans held a 48 to 47 edge during the 83rd Congress. In addition, Wayne Morse of Oregon was officially an independent, but usually voted with the Republicans. However, due to deaths and appointments following vacancies, Republicans actually lost their majority several times between 1953 and 1955. In fact, for a two-week period, Democrats actually held a majority. They never pursued the organizational resolution necessary to reclaim control of Senate committees. 27. Samuel Lubell, The Revolt of the Moderates (New York: Harper & Row, 1972), 25. 28. Pub. L. No. 83–591, 68A Stat. 3. 29. After the 1954 elections, Democrats held a slim 49– 47 advantage in the Senate and a more secure 232–203 majority in the House. 30. Cong. Rec., 85 Cong., 1st Sess., 5262. 31. The new strength of the GOP in the South led political analyst Kevin Phillips in 1969 to proclaim a “new Republican majority.” That turned out to be the case for the national Republican presidential party, but not for the GOP congressional party. Kevin Phillips, The Emerging Republican Majority (New Rochelle: Arlington House, 1969). 32. “Our political solar system, in short, has been characterized not by two

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Notes to Pages 48–52 equally competing suns, but by a sun and moon. It is within the majority party that the issues of any particular period are fought out; while the minority party shines in reflected radiance in the heat thus generated.” Samuel Lubell, The Future of American Politics 3d ed. (New York: Harper & Row, 1965), 191–92. 33. Driving Southern white segregationists out of the Democratic coalition made strategic sense from the perspective of a “mini-max” strategy. All that is needed to take control of government in a two-way election is to win by one vote more than 50 percent. Taking into account a margin for error in counting one’s supporters and predicting the outcome, a party acting rationally should attempt to win an election by as few votes as possible beyond the majority needed to win in order to share the “spoils” with as few as possible. This is a minimummaximum, or “mini-max” strategy. After the 1964 election, Johnson’s Democratic coalition was too large and necessarily had to be reduced (i.e., Johnson simply could not have satisfied all the disparate elements in the party, which included Northern liberals and Negro civil rights activists in the same coalition as Southern segregationists). From the perspective of game theory, Johnson was simply reducing his winning coalition to a more manageable (minimum) size. One of the first to apply mini-max game theory to political science was the late William Riker, who is fondly remembered and missed by his students and friends. See William H. Riker, The Theory of Political Coalitions (New Haven: Yale University Press, 1962). 34. An excellent account of the way in which Johnson’s support for the 1964 Civil Rights Act split the Democratic coalition and led to a restructuring of the party is found in Thomas Byrne Edsall (with Mary D. Edsall), Chain Reaction: The Impact of Race, Rights, and Taxes on American Politics (New York: W.W. Norton & Company, 1991), 32– 46. 35. Quoted in NYT, 6 November 1962, 21. 36. Barry Goldwater, The Conscience of a Conservative (Shepherdsville, Ky.: Victor Publishing, 1960), 61–62. 37. A perceptive account of the Goldwater candidacy is Reinhard, The Republican Right Since 1945, 159–208. See also Robert Alan Goldberg, Barry Goldwater (New Haven: Yale University Press, 1995). 38. The speech closed with the well-known declaration: “Extremism in the defense of liberty is no vice! . . . Moderation in the pursuit of justice is no virtue.” 39. Ronald Reagan, A Time for Choosing: The Speeches of Ronald Reagan 1961–1982 (Chicago: Regnery Gateway, 1983), 52. 40. Quoted in Goldberg, Barry Goldwater, 184. 41. The cover of the September/October 1964 issue of Fact magazine declared that “1,189 Psychiatrists Say Goldwater Is Psychologically Unfit To Be President.” Apparently, the magazine had sent about 12,000 psychiatrists a questionnaire asking whether they thought that the candidate was psychologically fit

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Notes to Pages 52–58 to serve as president. Nearly 10,000 refused to participate in the sham; 2,417 responded. The unsavory episode is told in Lee Edwards, Goldwater: The Man Who Made a Revolution (Washington, D.C.: Regnery Publishing, 1995), 318. 42. Nicol Rae argues that while such factors as changing demographics within the GOP, the weakening of party leadership over the candidate selection process, and the breakdown of consensus of the New Deal public philosophy greatly contributed to the rapid demise of the liberal wing of the Republican party. The failures of their own leadership exacerbated their decline. Nicol C. Rae, The Decline and Fall of the Liberal Republicans from 1952 to the Present (New York: Oxford University Press, 1989). 43. In the 1950s, the advice of Speaker Sam Rayburn to new Democratic members of Congress was “to get along, go along.” The same rule generally applied to Republican members as well—at least, until the 1980s and 1990s. 44. Congress finally indexed the tax brackets in 1981, thereby cutting off its own access to the automatic tax increases resulting from inflation. Thus ended the period of “easy financing” that characterized the 1960s and 1970s. For an excellent account of the shift from easy financing to the era of “fiscal straightjacket” that began in the early 1980s, see C. Eugene Steuerle, “Financing the American State at the Turn of the Century,” in W. Elliot Brownlee, Funding the Modern American State, 1941–1995: The Rise and Fall of the Era of Easy Finance (New York: Cambridge University Press, 1996), 409– 44. 45. Quoted in Lewis D. Eigen and Jonathan P. Siegel, The Macmillan Dictionary of Political Quotations (New York: Macmillan, 1993), 657. 46. John F. Witte, The Politics and Development of the Federal Income Tax (Madison: University of Wisconsin Press, 1985), 244 – 45. 47. Timothy J. Conlan, Margaret T. Wrightson, and David R. Beam, Taxing Choices: The Politics of Tax Reform (Washington, D.C.: Congressional Quarterly Press, 1990), 231–35. 48. John F. Kennedy, “January 1962 Economic Message,” in Public Papers of the Presidents, John F. Kennedy, 1962 (Washington, D.C.: GPO, 1963), 58. 49. Quoted in House Committee on Ways and Means, 91st Cong., 1st sess. (22 April 1969), Tax Reform Proposals, (Washington, D.C.: GPO, 1969), 1– 4. 50. Jimmy Carter, “Acceptance Speech Before the Democratic Party,” 15 July 1976, reprinted in NYT 16 July 1976, A10. 3

Regan Changes the Course

1. For a summary of the political science literature showing this decline in split votes within the parties in Congress, see Lawrence R. Jacobs and Robert Y. Shapiro, Politicians Don’t Pander: Political Manipulation and the Loss of Democratic Responsiveness (Chicago: University of Chicago Press, 2000). 2. This is the general theme of John Kingdon, Congressmen’s Voting Decisions (Ann Arbor: University of Michigan Press, 3d ed. 1989). 236

Notes to Pages 58–61 3. According to one account, Reagan met with his advisers only days after his election in California to consider his chances for capturing the presidency. F. Clifton White and William J. Gill, Why Reagan Won: A Narrative History of the Conservative Movement, 1964 –1981 (Chicago: Regnery Gateway, 1981), 87. 4. Reagan’s 1976 campaign against Ford is recounted in David W. Reinhard, The Republican Right Since 1945 (Lexington: University Press of Kentucky, 1983), 229–34. 5. See David A. Stockman, The Triumph of Politics: Why the Reagan Revolution Failed (New York: Harper & Row, 1986), 229. 6. Ronald Reagan, Inaugural Address, 20 January 1981 in Public Papers of the Presidents: Ronald Reagan, 1981 (Washington, D.C.: GPO, 1982), 1. 7. Ibid., 2. 8. Pub. L. No. 97–34, 95 Stat. 172. The final bill passed both houses, 303 members of Congress voting in favor and 107 against. All but one Republican in Congress voted for the bill, and Democrats were almost evenly split. 9. ERTA provided rate reductions of 5 percent, 10 percent, and 10 percent over three successive years, effective beginning October 1, 1981. This amounted to a 23 percent rate reduction; however, the full effect of ERTA rate reductions was offset by subsequent legislation. 10. See, e.g., John F. Witte, “The Tax Reform Act of 1986: A New Era in Tax Politics?” American Political Quarterly 19 (1991): 438, 443. “The 1981 Economic Recovery Act (ERTA) stands as the most strident anti-reform bill”; Daniel Shaviro, “Beyond Public Choice and Public Interest: A Study of the Legislative Process as Illustrated by Tax Legislation in the 1980s,” University of Pennsylvania Law Review 139 (1990): 108. “[M]ost supporters of tax reform would agree [that ERTA] was almost pathologically bad special interest legislation.” 11. Timothy J. Conlan, Margaret T. Wrightson, and David R. Beam, Taxing Choices: The Politics of Tax Reform (Washington, D.C.: Congressional Quarterly Press, 1990), 33–34. See also John F. Witte, The Politics and Development of the Federal Income Tax (Madison: University of Wisconsin Press, 1985), 224: “[W]ith each successive round of bargaining, the bill widened in scope.” In contrast, Bruce Bartlett, who served as Deputy Assistant Secretary for Economic Policy in the Treasury Department during the Reagan administration, disputes this assessment of the role of special interests. “[T]here was no feeding frenzy. The tax cut that was enacted in August 1981 closely resembled the tax cut put forward by Ronald Reagan during the campaign. Very little was added that had any substantial effect on revenue.” Bruce Bartlett, “The Myth of the ‘Feeding Frenzy,’ ” The Weekly Standard, 19 February 2001, 16. The same charge is repeated by a senior editor of National Review magazine, who first denies that there was a feeding frenzy in 1981 (a claim which he denounces as a part of “liberal mythology”) and then suggests that a “bidding war on taxes . . . is a useful 237

Notes to Pages 61–63 corrective” to overspending by Congress. Ramesh Ponnuru, “What’s Wrong with a Tax-Cut Feeding Frenzy?” WSJ, 28 February 2001, A22. 12. The role of probusiness groups, such as the American Council for Capital Formation, lobbying for and even designing favorable depreciation schedules during the drafting stage for the 1981 tax bill, is recalled in Jacob Schlesinger and John D. McKinnon, “Bush Tax Cuts Send Corporate Lobbyists into a Feeding Frenzy,” WSJ, 2 February 2001, A1. 13. Cathie J. Martin offers the most insightful account of the motivations and interests of the various business groups with respect to provisions in the 1981 tax bill. Cathie Jo Martin, “American Business and the Taxing State: Alliances for Growth in the Postwar Period,” in W. Elliot Brownlee (ed.), Funding the Modern American State, 1941–1995: The Rise and Fall of the Era of Easy Finance (New York: Cambridge University Press, 1996). See also Cathie J. Martin, Shifting the Burden: The Struggle over Growth and Corporate Taxation (Chicago: University of Chicago Press, 1991), 114 –31. A recent study traces the long-term attitude and political tactics of one specific sector of business (pharmaceuticals and high-tech firms) in lobbying for the enactment and retention of the IRC section 931 (and its successor provision, IRC section 936) tax credit for investment in U.S. “possessions”—most particularly, Puerto Rico. Sandra L. Su´arez, Does Business Learn?: Tax Breaks, Uncertainty, and Political Strategies (Ann Arbor: University of Michigan Press, 2000). 14. Economist Arthur Laffer was the main academic proponent of supplyside economics. Jude Wanniski was a tireless spokesman for the supply-side philosophy. Supporters in the government included Norman Ture (Treasury) and Paul Craig Roberts, who was economic adviser to Representative Jack Kemp in 1975, and perhaps the most committed supply-siders inside the Reagan administration. His own account of the “rise” of supply-side economics is presented in Paul Craig Roberts, The Supply-Side Revolution (Cambridge: Harvard University Press, 1984). 15. Arthur Laffer has consistently argued that cutting taxes would result in greater overall revenue under the income tax. To this day, he remains committed to this basic principle of supply-side economics. See Arthur B. Laffer, “To Soak the Rich, Cut Their Taxes,” WSJ, 24 October 2000, A26. 16. Supply-side economists such as Lawrence Lindsey, now President George W. Bush’s chief economic adviser, only claim a behavioral response from the tax cuts that would offset, but not necessarily outweigh the revenue lost from the reduction of marginal tax rates. On the other hand, the overall increase to society in economic wealth could exceed the net revenue lost to the government. See e.g., Lawrence B. Lindsey, The Growth Experiment: How the New Tax Policy Is Transforming the U.S. Economy (New York: Basic Books, 1990), 53–80. Recently, the editors of the Wall Street Journal complained that the Joint Committee on Taxation overestimated the cost of the Bush tax cut by as much as $4 trillion by failing to take into account the added revenue that would supposedly flow into 238

Notes to Pages 63–66 the Treasury because of economic growth attributable to the tax cut itself. “A Real Tax Cut,” WSJ, 22 May 2001, A26. 17. The Revenue Reconciliation Act of 1993 enacted new Subchapter U, found at new sections 1391 et seq. of the Internal Revenue Code. The 1993 provision provides for a general business tax credit for certain wages paid to “qualified zone employees.” This “empowerment zone employment credit” was considerably less than what was proposed by Kemp. The number of empowerment zones and the tax benefits associated with them were expanded by tax legislation in 1997 and 2000. 18. Barry P. Bosworth, Tax Incentives and Economic Growth (Washington, D.C.: Brookings Institution, 1984), 7. 19. Economist Bruce Bartlett places the blame for the deficits that followed the 1981 tax cut on the recession that hit in late 1981–1982 and the sharp decline in interest rates that reduced GDP below levels projected in prior budgets. Bartlett, “Myth of the ‘Feeding Frenzy,’ ” 17. 20. The actions of business groups that urged Reagan to raise taxes and reduce the deficits are recounted in Martin, Shifting the Burden, 146– 47. 21. Pub. L. No. 97–248, 96 Stat. 324. 22. I provide a more detailed description of the use and abuse of the safeharbor lease provision in The Failure of U.S. Tax Policy: Revenue and Politics (State Park: Pennsylvania State University Press, 1996), 91–92. 23. The DEFRA tax provisions were enacted as the Tax Reform Act of 1984. Pub. L. No. 98–369, 98 Stat. 494. 24. Congressional Record, 97th Cong., 2d sess. (19 August 1982), Vol. 128, pt. 16, 22408. 25. Ironically, while Kemp lost his bids for the GOP presidential nomination, he later joined the GOP’s 1996 ticket as Bob Dole’s running mate. They suffered a humiliating loss to incumbent Democrats Bill Clinton and Al Gore. 26. “Let us go forward with an historic reform for fairness, simplicity and incentives for growth. I am asking Secretary Don Regan for a plan for action to simplify the entire tax code, so all taxpayers, big and small, are treated more fairly.” Ronald Reagan, “Address Before a Joint Session of the Congress on the State of the Union” (25 January 1984), in Public Papers of the Presidents: Ronald Reagan, 1984 (Washington, D.C.: GPO, 1986), Vol. 1, 87. 27. Ibid., 89. 28. Pub. L. No. 99–514, 100 Stat. 2085. The best accounts of the politics behind the Tax Reform Act of 1986 are Timothy J. Conlan, Margaret T. Wrightson, and David R. Beam, Taxing Choices: The Politics of Tax Reform (Washington, D.C.: Congressional Quarterly Press, 1990); Jeffrey H. Birnbaum and Alan S. Murray, Showdown at Gucci Gulch: Lawmakers, Lobbyists, and the Unlikely Triumph of Tax Reform (New York: Vintage, 1988); Martin, Shifting the Burden, 159–89. See also Pollack, The Failure of U.S. Tax Policy, 98–106, 112–13, 175–76, 183–87. 239

Notes to Pages 66–69 29. See, e.g., Witte, “Tax Reform Act,” 4: “TRA can only be viewed as a remarkable legislative accomplishment and by far the most radical example of peacetime tax reform in history”; Shaviro, “Beyond Public Choice,” 5: “[T]he 1986 Act was the all-time leading example of tax reform.” 30. While the 1986 tax act was cast in terms of revenue neutrality, with the distribution of the corporate tax increases imposed on upper income taxpayers, the legislation worked a slight increase in the progressivity of the income tax. See Henry J. Aaron, “The Impossible Dream Comes True,” in Tax Reform and the U.S. Economy, ed. Joseph A. Pechman (Washington, D.C.: Brookings Institution Press, 1987), 13–14. 31. Congressional Budget Office, The Economy and Budget Outlook: Fiscal Years 1991–1995 (Washington, D.C.: GPO, January 1990), app. E, table E-2. 32. The Balanced Budget and Emergency Deficit Control Act of 1985 (socalled Gramm-Rudman-Hollings). Pub. L. No. 99–171, 99 Stat. 1037, sec. 200 et seq. 33. For an account of the partisan political battle between the new Bush administration and the Democratic Congress over the FY 1990 budget, see Howard E. Shuman, Politics and the Budget: The Struggle Between the President and Congress (Engelwood Cliffs, N.J.: Prentice-Hall, 1992), 304 –11. Shuman argues that the antagonism arising from the President’s mishandling of negotiations over the fiscal year 1990 budget led to the subsequent conflict over the 1991 budget. 34. At first, the administration interpreted the President’s “no-new-taxes” pledge to apply only to income taxes, allowing agreement to be reached over increased user fees and a ten-cent increase in the gasoline tax. Under sustained pressure, the White House eventually accepted an increase in the top individual tax rate from 28 percent to 31 percent, with the tax on long-term capital gains capped at 28 percent as a compromise. 35. Much has been written of the political hay made by Democrats over the administration’s many strategic blunders in the negotiations. See, e.g., Alan Murray and Jackie Calmes, “How the Democrats, with Rare Cunning, Won the Budget War,” WSJ, 5 November 1990, A1; Donald F. Kettl, Deficit Politics: Public Budgeting in Its Institutional and Historical Context (New York: Macmillan, 1992), 3–12; Steuerle, Tax Decade, 173–84; Shuman, Politics of the Budget, 314 –17. 36. The discussion of the 1990 and 1992 tax bills that follows builds upon my prior analysis in The Failure of U.S. Tax Policy: Revenue and Politics (University Park: Penn State Press, 1996), 117–22. 37. While a taxpayer crosses the threshold for the “phaseout” of personal exemptions, which in 1993 began at adjusted gross income (AGI) of $100,000 for a single taxpayer, as well as the threshold for the phased-in reduction in the enumerated deductions, which began at $150,000, the effective marginal tax rate was 34 percent, and not the statutory 31 percent. 38. For a comprehensive and detailed analysis of how the phaseout of 240

Notes to Pages 69–76 personal exemptions and itemized deductions effects marginal tax rates, see Elliot Manning and Laurence M. Andress, “The 1996 Marginal Federal Income Tax Rates: The Image and the Reality,” Tax Notes, 30 December 1996, 1585. See also Gene Steuerle, “The True Tax Rate Structure,” Tax Notes, 16 October 1995, 371 (benefit phaseouts as implicit tax rate hike) and “Bubbles, Bangles and Beads: Fixing Up the Top Rate,” Tax Notes, 19 April 1993, 425.

4

The Tax Deadlock Decade

1. C. Eugene Steuerle, The Tax Decade: How Taxes Came to Dominate the Public Agenda (Washington, D.C.: Urban Institute Press, 1992), 3. 2. Aaron B. Wildavsky, The New Politics of the Budgetary Process, 3rd ed. (New York: Addison, Wesley, Longman, 1997), xxiii. 3. Quoted in Tax Notes, 17 May 1999, 966. 4. Budget expert Stanley Collender traces a heightened concern with the deficit to the 1992 elections. “[T]he 1992 elections produced the first recognizable change in budget politics in decades. Deficit reduction suddenly became a politically acceptable position for candidates for federal office . . .” Stanley E. Collender, The Guide to the Federal Budget: Fiscal 1995 (Washington, D.C.: Urban Institute Press, 1994), xiii. 5. A detailed description of the White House tax proposals is found in the study by the Joint Committee on Taxation, Summary of the President’s Revenue Proposals (JCS-4 –93), 8 March 1993. 6. Pub. L. No. 103–66, 107 Stat. 312. 7. James MacGregor Burns, The Deadlock of Democracy; Four-Party Politics in America (Englewood Cliffs, N.J.: Prentice-Hall, 1963). The reference to a “four-party” system reflects Burns’s notion that there are two national political parties that contest for seats in Congress and two other national political parties that vie for control of the White House. Hence, even when Democrats have controlled both branches, the different constituencies of the two Democratic coalitions (one centered around the legislature and the other around the executive) have produced political conflict, rather than a harmony of interests. Witness the presidency of Jimmy Carter and the death of his tax legislative initiatives at the hands of a Democratic Congress. 8. Nicol C. Rae, Conservative Reformers: The Republican Freshmen and the Lessons of the 104th Congress (Armonk, N.Y.: M.E. Sharpe, 1998), 35. 9. Ibid., 39– 40. 10. “In 1994, there was an apparent partisan realignment going on in one particular and major geographic region, namely, the American South.” Byron E. Shafer, “The Mid-Term Election of 1994: An Upheaval in Search of a Framework,” in The Republican Takeover of Congress, ed. Dean McSweeney and John E. Owens (New York: St. Martin’s Press, 1998), 17. 241

Notes to Pages 77–82 11. This is the main theme of Richard F. Fenno Jr., Learning to Govern: An Institutional View of the 104th Congress (Washington, D.C.: Brookings Institution Press, 1997). 12. For an account of the new Republican rules, see Roger H. Davidson, “Building the Republican Regime: Leaders and Committees,” New Majority or Old Minority: The Impact of Republicans on Congress ed. in Nicol C. Rae and Colton C. Campbell (Lanham, Md.: Rowman & Littlefield, 1999), 69–90. 13. For a description of the workings of the Committee on Committees, as well as the other GOP leadership organizations, see William F. Connelly Jr. and John J. Pitney Jr., Congress’ Permanent Minority? Republicans in the U.S. Congress (Lanham, Md.: Rowman & Littlefield, 1994), 42– 45. See also Barbara Sinclair, “Partisan Imperatives and Institutional Restraints: Republican Party Leadership in the Senate and House,” in New Majority or Old Minority, 21– 41. 14. Article I, Section 7 of the U.S. Constitution provides: “All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with Amendments as on other Bills.” Despite this, in two notable cases (Lyndon Johnson’s 1968 surtax to help finance the Vietnam war and the revenue provisions of TEFRA 1982), major tax legislation originated in the Senate. These apparent breaches of the Constitution went unchallenged in the federal courts. 15. Quoted in Daily Tax Rep. (Bureau of National Affairs), No. 218, 15 November 1994, G-6. 16. Quoted In Melinda Henneberger, “Tom DeLay Holds No Gavel, But a Firm Grip on the Reins,” NYT, 21 June 1999, A10. 17. The best analysis of the views and backgrounds of the members of the GOP freshman class is Nicol Rae, Conservative Reformers, 62–67. Rae concludes that despite the differences, the House GOP freshman were not political “outsiders” to the degree reflected in their own rhetoric. 18. For an description of the background, careers, and views of many of the GOP freshmen before coming to Congress, see Linda Killian, The Freshmen: What Happened to the Republican Revolution (Boulder, Colo.: Westview Press, 1998), 13–23. 19. Ibid., 77. 20. Gingrich’s leadership style during the first 100 days of the 104th Congress is assessed in Barbara Sinclair, “Leading the Revolution: Innovation and Continuity in Congressional Party Leadership,” in Republican Takeover, 71– 95. 21. Joint Committee on Taxation, Estimated Budget Effects of Revenue Reconciliation and Tax Simplification Provision of H.R. 2491 (JCX-53-95), 16 November 1995. 22. Quoted in Tax Notes (20 February 1995), 1083. 23. The flat tax was originally proposed by Robert E. Hall and Alvin Rabushka in a 1981 article in the Wall Street Journal and later developed into a 242

Notes to Pages 82–87 full proposal in Low Tax, Simple Tax, Flat Tax (New York: McGraw-Hill, 1983). The plan was subsequently refined in The Flat Tax (Stanford, Calif.: Hoover Institution Press, 1985). A recent summary and assessment of the flat tax proposal is found in John O. Fox, If Americans Really Understood the Income Tax (Boulder, Colo.: Westview, 2001), 254 –79. 24. Joint Committee on Taxation, Discussion of Issues Relating to Flat Tax Rate Proposals (JCS-7–95), 3 April 1995; see also Joint Committee on Taxation, Description and Analysis of Proposals to Replace the Federal Income Tax (JCS-18– 95), 5 June 1995. 25. Steve Forbes, “Presidential Announcement Speech,” National Press Club, 22 September 1995. 26. Quoted in David Hess, “Congress to Ponder Tax, Education and Social Security Bills,” Philadelphia Inquirer, 6 January 1999, A11. 27. At a news conference in April 1995, a reporter asked President Clinton if being pushed to the sidelines by the Republicans in Congress made him “irrelevant.” His response: “The president is relevant, especially an activist president, and the fact that I am willing to work with Republicans. The Constitution gives me relevance; the power of our ideas gives me relevance; the record we have built up over the last two years give me relevance.” 28. These included limiting the carryback of net operating losses to one year (down from three), restricting the use of so-called captive insurance companies, reducing the “dividends received” deduction (available to corporations owning less than 20 percent of the stock of another corporation) from 70 percent to 50 percent, and phasing out one major component of the Section 936 “possessions” tax credit. For a description of the White House tax proposals, see Lauren Darling, “Clinton’s Budget Plan Takes Aim At ‘Abusive’ Corporate Loopholes,” Daily Tax Report (BNA), No. 236, 8 December 1995, G-10. 29. Congressional Budget Office, “The Economic and Budget Outlook: December 1995 Update,” Washington, D.C., 11 December 1995. 30. H.R. 2586, approved by the House Ways and Means Committee on November 7, 1995, increased the statutory limit on the public debt to $4.95 trillion for debt outstanding prior to December 13, 1995. This provided a few weeks breathing room for negotiations between the White House and Congress. 31. Congress and the administration did not reach agreement on the 1996 budget until six months into the fiscal year. The fiscal 1996 omnibus appropriations bill (H.R. 3019) was signed by President Clinton on April 26, 1996. 32. See John Godfrey, “Chances Dim for Tax Plan to Ride on Debt Limit Bill,” Tax Notes, 4 March 1996, 1303. 33. See Heidi Glenn, “GOP Moves to Limit Contract, ‘Renew’ Distressed Cities,” Tax Notes, 4 March 1996, 1309. 34. See ibid., “Congress Passes Debt Limit Bill, Limited Line-Item Veto,” Tax Notes, 1 April 1996, 7. 35. P.L. 104 –130, 110 Stat. 1200; 2 U.S.C. §691 et seq. 243

Notes to Pages 87–94 36. Judicial challenges to the line item veto quickly left the legal status of the measure in limbo. On February 12, 1998, a U.S. district court declared the Line Item Veto Act unconstitutional as a violation of Article I, Section 7 of the U.S. Constitution, as well as the “separation of powers” doctrine. After granting expedited review, the Supreme Court held the line item veto unconstitutional in a 6 to 3 decision. William J. Clinton, President of the United States, et al. v. City of New York, 524 U.S. 417 (25 June 1998). 37. The provisions creating FASITs are found at IRC sections 860H through 860L. For a brief description of the entity, see Sheldon D. Pollack, “FASITs: Entity of Choice for Securitization of Debt,” The Legal Intelligencer, 3 February 1997, 11–12. 38. See John Godfrey, “Senate Takes Policy Lead as Congressional Session Begins,” Tax Notes, 13 January 1997, 111. 39. See ibid. “GOP Leaders Seek White House Tax Reform Proposal,” Tax Notes, 17 February 1997, 826. 40. See ibid., “House GOP Unveils Agenda; Tax Plans Remain Murky,” Tax Notes, 10 March 1997, 1227. 41. P.L. 105–34, 111 Stat. 788. 42. For an in-depth discussion of the corporate alternative income tax, see Andrew B. Lyons, Cracking the Code: Making Sense of the Corporate Alternative Minimum Tax (Washington, D.C.: Brookings Institution Press, 1997). 43. The same dubious honor was subsequently awarded to Bill Archer, Republican chairman of the House Ways and Means Committee, for whom the Archer MSA (Medical Savings Account) was named. See IRC section 220. 44. Quoted in WSJ, 14 March 2001, A1. 45. The story of John Kimble’s campaign in the 2000 congressional election, and his proposed tax credit for pets, is recounted in Matt Labash, “A WynnWynn Situation: It May be the Most Ridiculous Congressional Race in America,” The Weekly Standard, 6 November 2000, 16. 46. Paul Krugman, “Gore’s Tax Problem,” NYT, 10 September 2000, WK 17. 47. Those provisions were found at former IRC sections 1034 and 121, respectively. 48. For an account of the politics behind the provision to repeal the tax code, see Ryan J. Donmoyer, “In Election-Year Gambit, House Votes to Scrap Code,” Tax Notes, 22 June 1998, 1533. An identical version of the bill (H.R. 4199) was subsequently passed by the House 229–187 during the 106th Congress, and Largent has already introduced a comparable bill (H.R. 2714) in the 107th Congress. 49. The following account of the 1997 campaign against the IRS draws upon my essay, “The Politics of Taxation” in Handbook of Government Budgeting, ed. Roy T. Meyers, (San Francisco: Jossey-Bass Publishers, 1999), 332–54; see also

244

Notes to Pages 94 –95 Sheldon D. Pollack, “The Politics of Taxation: Who Pays What, When, How,” unpublished paper presented to Annual Meeting of the American Political Science Association, Boston, Massachusetts, 3–6 September 1998. 50. For discussion of those reports that disprove the allegations made against the IRS can be found summarized, see Amy Hamilton, “Court Dismissed Outspoken Agent’s Complaint Against IRS,” Tax Notes, 12 March 2001, 1457; Tax Notes, 26 April 1999, 455; 51. The House passed the Conference Committee report to H.R. 2676 on June 25 by a vote of 402–8, and the Senate followed on July 9, by a vote of 96–2. President Clinton signed the bill into law on July 22, 1998. 52. See Greg Hitt, “Lawmakers Strike Deal on IRS Overhaul,” WSJ, 24 June 1998, A2. 53. For an in-depth analysis of the 1998 act, see Robert Manning and David F. Windish, “The IRS Restructuring and Reform Act: An Explanation,” Tax Notes, 6 July 1998, 83. 54. On account of political squabbling, it was not until August 2000 that all of the President’s nominations were approved. The board itself did not actually meet until September 2000. 55. See George Guttman, “IRS Oversight Board Working on Taxpayer Advocate Appointment,” Tax Notes, 8 January 2001, 143. 56. These provisions are described in detail in Robert Manning and David F. Windish, “The IRS Restructuring and Reform Act: An Explanation,” Tax Notes, 6 July 1998, 83. 57. The political bargaining in the Conference Committee over the 1998 tax bill is described in Ryan J. Donmoyer, “Loaded-Up IRS Restructuring Bill Awaits Senate Approval,” Tax Notes, 29 June 1998, 1663; Sheryl Stratton, “Accountant-Client Privilege: Unclear from the Start,” 80 Tax Notes, 6 July 1998, 7. 58. The “ten deadly sins” are enumerated in section 1203 of the Internal Revenue Service Restructuring and Reform Act of 1998. An IRS employee will be fired automatically for one of these infractions, which include filing his own tax return late—even by one day. For an account of how this statute has affected IRS enforcement efforts, see Lee A. Sheppard, “The Sixth Deadly Sin,” Tax Notes, 20 August 2001, 1018. 59. For an account of the decline in audit rates, see Christopher Bergin, “IRS Audit Rate Takes Another Dramatic Drop,” Tax Notes, 19 February 2001, 982. These statistics can be misleading, as there are several definitions about what constitutes an “audit.” The term also includes IRS computer contacts with taxpayers, and not just face-to-face meetings. See George Guttman, “Current Audit Statistics Make IRS Look Less Effective Than It Is,” Tax Notes, 19 March 2001, 1593. 60. For an account of how the reduction of the holding period for capital

245

Notes to Pages 95–99 gains was included in the IRS restructuring bill, see Richard W. Stevenson, “Break in Capital Gains Tax Is Added to I.R.S. Overhaul,” NYT, 24 June 1998, A1. 61. Joint Committee on Taxation, Estimated Budget Effects of Internal Revenue Service Restructuring and Reform Act of 1998 (JCX-51-98), 24 June 1998. 62. The story of Archer’s opposition to this technical correction is found in David E. Rosenbaum, “A Mistake Prevails, as Certainly as Death and Taxes,” NYT, 24 June 1998, A21. 63. See Greg Hitt, “IRS Bill, Poised for Senate Approval, Also Has Benefits for Special Interests,” WSJ, 9 July 1998, A20. 64. House Ways and Means Committee member John Ensign (R-Nev.) was successful in slipping into the IRS restructuring bill a proposal that he had introduced in the House in May. That bill, the Worker Meal Fairness Act of 1998, was cosponsored in the Senate by Speaker Newt Gingrich (R-Ga.). For an account of Ensign’s lobbying, as well as the impact of the provision, see Amy Hamilton, “IRS Reform’s Flying Circus—Tales of One Last-Minute Change,” Tax Notes, 13 July 1998, 145. 65. Schmidt Baking Co. Inc., 107 T.C. 271 (1996). 66. Joint Committee on Taxation, Estimated Budget Effects of Internal Revenue Service Restructuring and Reform Act of 1998 (JCX-51-98), 24 June 1998. 67. Quoted in The Financial Times (London), USA Edition, 7 November 1998, 1. 68. The credit (effective for taxable years beginning after December 31, 1999) would be phased out for married taxpayers filing a joint return with income in excess of $110,00, and at $75,000 for single taxpayers. Department of the Treasury, General Explanation of the Administration’s Revenue Proposals (Washington, D.C.: U.S. Department of the Treasury, February 1999), 1. 69. The entire package was included in the Budget of the United States Government, Fiscal Year 2000 (submitted to Congress by President Clinton, 2 February 1999), and is described in detail in Department of the Treasury, General Explanation of the Administration’s Revenue Proposals (Washington, D.C.: U.S. Department of the Treasury, February 1999). 70. According to Treasury, the current 20-year carryforward period would not be changed and only losses related to activities incurred in the manufacture or production of steel and steel products would be eligible for the fiveyear carryback. Department of the Treasury, General Explanation of the Administration’s Revenue Proposals (Washington, D.C.: U.S. Department of the Treasury, February 1999), 91. For an account of the politics behind the proposal, see Bob Davis, “White House Proposes Some Tax Breaks for Steel Industry, Pressures Japan,” WSJ, 8 January 1999, A2. 71. Congressional Budget Office, “Month Budget Review Fiscal Year 1999,” Washington, D.C., 10 November 1999.

246

Notes to Pages 102–105 72. Joint Committee on Taxation, Estimated Budget Effects of the Conference Agreement for H.R. 2488 (JCX-61-99R), 5 August 1999. 73. The Bush tax plan is described in Jay Root, “Bush Talks Up Tax Plan,” Philadelphia Inquirer, 2 December 1999, A28; Ryan J. Donmoyer and Heidi Glenn, “Something for Everyone? Bush Proposes $483 Billion Cut,” Tax Notes, 6 December 1999, 1223. 74. There never was an official scoring of the Bush plan, estimates of its 10-year cost range from $1.3 to $1.7 trillion. The Bush camp scored the plan relying upon a projected economic growth rate of 2.7 percent, as opposed to the more conservative 2.3 percent forecast of CBO. 75. A June 1999 Wall Street Journal/NBC News poll found that only 9 percent of voters thought that tax cuts should be the highest priority of the government. Improvements to public education, shoring up Social Security, and promoting strong moral values all topped tax cuts as issues with significant voter appeal. More recent polls conducted on or around February 28, 2001, when George Bush actually presented his $1.6 trillion tax cut plan to Congress, showed pretty much the same set of priorities. However, a New York Times/CBS News poll in March 2001 found that 57 percent of those surveyed supported Bush’s tax cut, as opposed to 36 percent who opposed it. 76. According to Robert Reischauer, formerly of the Brookings Institution, discretionary spending since 1992 has actually shrunk as a share of GDP from 3.5 percent to 3.2 percent. 77. “Expenditure caps, which allow outlays to increase but only up to a given threshold, are an obvious attempt to reconcile specific promises and aggregate fiscal management.” Ronald F. King, Budgeting Entitlements: The Politics of Food Stamps (Washington, D.C.: Georgetown University Press, 2000), 23. 78. The action of the Federal Reserve Board is explained in “Treasury to Receive $3.5 Billion From Fed, Balancing Budget,” WSJ, 19 November 1999, A22. 79. McCain was quoted in Jeffrey Taylor, “McCain Criticizes Budget Deal’s ‘Pork’ in Latest Attack,” WSJ, 23 November 1999, A24. 80. Congressional Budget Office, “The Budget for Fiscal Year 2000: An End-of-Session Summary,” Washington, D.C., 2 December 1999. 81. Joint Committee on Taxation, Estimated Budget Effects of the Revenue Provisions Included in the Conference Agreement for H.R. 1180 (JCX-86-99), 18 November 1999. 82. Pub. L. No. 106–170, 113 Stat. 1860. 83. Ryan J. Donmoyer, “Businesses Feed on the Surplus as Extenders are Completed,” Tax Notes, 22 November 1999, 975; see also Joint Committee on Taxation, Estimated Budget Effects of Conference Agreement on H.R. 1180 Relating to Expiring Tax Provisions and Other Revenue Provisions (JCX-86-99), 18 November 1999.

247

Notes to Pages 105–110 84. This credit is found at IRC section 41. 85. The credit is evaluated in Martin Sullivan, “The Research Credit: A Perfect Example of an Imperfect Code,” Tax Notes, 11 October 1999, 128. 86. This credit is found at IRC section 45 87. For an account of how Roth’s provision found its way into the legislation, see Herman P. Ayayo, “APA Secrecy, Poultry Waste Credit Survive Legislative Endgame,” Tax Notes, 29 November 1999, 1120. Roth faced former Democratic Governor Thomas Carper in his bid for reelection in 2000. 88. Quoted in Jeffrey Taylor and Laurie McGinley, “House Approves Tax-Break Extension,” WSJ, 19 November 1999, A4.

5

Tax Policy in the Twenty-first Century

1. Quoted in “Finance to Mark Up Marriage Tax Bill,” Tax Notes, 16 June 2000, 1755. 2. Joint Committee on Taxation, Estimated Revenue Effects of the Chairman’s Mark of the Marriage Tax Penalty Relief Act of 2000 (JCX-5-00), 1 February 2000. 3. An interesting account of the dispute over Parliamentarian Dove’s ruling, and how Senate Republicans have taken advantage of it, is found in David Rogers, “Bush’s Ace in the Hole in Tax Fight May Be Senate’s Rules Expert,” WSJ, 1 March 2001, A24. Subsequently, Dove expressed doubt about whether use of the reconciliation process for a tax cut of the magnitude proposed by the Republicans was appropriate. This put Dove at odds with Senate Majority Leader Lott, eventually resulting in Dove’s dismissal from the position as parliamentarian. The story of Dove’s dismissal was reported in “Key Senate Official Loses Job in Dispute with GOP,” Washington Post, 8 May 2001, A1. 4. The Senate version was scored at $55 billion over ten years. Joint Committee on Taxation, Estimated Revenue Effects of the Marriage Tax Penalty Relief Reconciliation Act of 2000, as Reported by the Committee on Finance on June 28, 2000 (JCX-65-00), 30 June 2000. 5. A description of the conference bill is found in Joint Committee on Taxation, Summary of Provisions Included in the Conference Agreement for the Marriage Tax Relief Reconciliation Act of 2000 (H.R. 4810) (JCX-82-00), 20 July 2000. 6. Quoted in Marc Lacey, “President’s Veto Sets Up a Battle on Marriage Tax,” NYT, 6 August 2000, 1. 7. Quoted in Heidi Glenn, “Clinton Rejects GOP Tax Cut for Married Couples,” Tax Notes, 14 August 2000, 847. 8. Nicholas Bull, Janet Holtzblatt, James R. Nunns, and Robert Rebelein, “Defining and Measuring Marriage Penalties and Bonuses,” OTA Paper 82– Revised, Office of Tax Analysis, Department of Treasury (November 1999). 248

Notes to Pages 110–116 9. Under the law of community property states, all of the property and income of a married couple is deemed owned 50/50, regardless of how the property is titled or who earned it. 10. 281 U.S. 111 (1930). 11. For those interested in a more detailed description of the various permutations of the marriage tax penalty and why it cannot so easily be remedied, see Michael J. Graetz, The Decline (and Fall?) of the Income Tax (New York: W.W. Norton, 1997), 29– 40. For a detailed history and analysis of the marriage penalty, see Angela V. Langlotz, “Tying the Knot: The Tax Consequences of Marriage,” Tax Lawyer 54 (Winter 2001): 329. For a broader discussion of the problems that arise from the taxation of women in the workplace, see Edward J. McCaffery, Taxing Women (Chicago: University of Chicago Press, 1997). 12. The Republican proposal for relief from the marriage tax penalty was recently criticized from those among the New Right on the grounds that it promotes an “anti-marriage” bias by moving toward a tax system in which married taxpayers are treated as individuals, rather than a single unit. See Allan Carlson and David Blankenhorn, “Marriage Penalties: What’s Good and What’s Bad in Bush’s Tax Plan,” The Weekly Standard, 26 February 2001, 19–20. 13. Quoted in Daily Tax Rep. (Bureau of National Affairs), No. 193, 7 October 1993, G-3. 14. The problems arising from section 527 organizations, and recent legislation requiring greater disclosure from them, are discussed in Frances R. Hill, “Softer Money: Exempt Organizations and Campaign Finance,” Tax Notes, 16 April 2001, 477; “Probing the Limits of Section 527 to Design a New Campaign Finance Vehicle,” Tax Notes, 17 January 2000, 387. See also Martin A. Sullivan, “More Disclosure From 501(c)s: Poison Pill or Good Policy?” Tax Notes, 26 June 2000, 1681; Marie B. Morris, “527 Organizations: How the Differences in Tax and Election Laws Permit Certain Organizations to Engage in Issue Advocacy Without Public Disclosure and Proposals for Change,” CRS Report for Congress, 26 June 2000. 15. The legislation was enacted as Pub. L. No. 106–230, 114 Stat.477. 16. See Ryan J. Donmoyer and Heidi Glenn, “Senate Finance Committee Joins the Corporate Tax Shelter Debate,” Tax Notes, 29 May 2000, 1175. 17. ILM 200034029, Doc 2000–22079 (released 28 August 2000) 18. Pub. L. No. 106–519, 114 Stat. 2423. 19. With the enactment of the Community Renewal Tax Relief Act of 2001, the tax code now provides for four different types of tax-favored enterprise zones: empowerment zones, renewal communities, enterprise communities, and the District of Columbia Enterprise Zone. 20. Pub. L. No. 106–554, 114 Stat. 2763. 21. See Martin A. Sullivan, “Hundreds of Tax Credits Sought by the 106th Congress,” Tax Notes, 18 December 2000, 1536. 249

Notes to Pages 119–126 22. Quoted in WSJ, 22 February 2001, A24. 23. The many different price tags attached to President Bush’s tax cut plan ($1.3 trillion, $1.6 trillion, $2.1 trillion, etc.) were attributable to using very different methodologies. See Heidei Glenn, “The Many Pricetags of George W.’s Tax Cut,” Tax Notes, 15 January 2001, 274. 24. Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2002–2011 (Washington, D.C.: GPO, January 2001). 25. President George W. Bush, Address to a Joint Session of Congress, 27 February 2001. 26. In April 2001, the Joint Committee on Taxation issued a bold and comprehensive three-volume study on how to simplify the federal tax system. High on the list of the JCT is the complete repeal of the AMT, both for individuals and corporations. See Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification (JCS-3–01), April 2001, Vol. II, 2–22. 27. See Robert Rebelein and Jerry Tempalski, “Who Pays the Individual AMT?” Working Paper No. 87, Office of Tax Analysis, Department of Treasury (June 2000). For a discussion of the impending problems with the AMT, see Martin A. Sullivan, “Like Gasoline on a Fire, House Bill Fuels AMT’s Problems,” Tax Notes, 12 March 2001, 1443. 28. Joint Committee on Taxation, Estimated Revenue Effects of H.R. 3, the “Economic Growth and Tax Relief Act of 2001,” as Reported by the Committee on Ways and Means (JCX-7-01), 6 March 2001. 29. Quoted in Tax Notes, 28 May 2000, 1470. 30. For an account of how Democrats got on board the campaign for AMT relief, see Shailagh Murray, “Change in Minimum Tax Gets New Backers: Democrats,” WSJ, 23 March 2001, A16. 31. An excellent description of how the Bush team successfully cultivated support with small business groups such as NFIB, the U.S. Chamber of Commerce, and the National Association of Wholesaler-Distributors, even while bringing large corporations and Big Business on board through promises of future tax benefits, is found in Elizabeth Drew, “Bush’s Weird Tax Cut,” New York Review of Books, 9 August 2001, 50. 32. The revenue estimates for the House bill are found in Joint Committee on Taxation, Estimated Revenue Effects of H.R. 3, the “Economic Growth and Tax Relief Act of 2001,” as Reported by the Committee on Ways and Means (JCX-7-01), 6 March 2001. 33. The details of the Democratic plan are laid out in “Democrats Fill in Details of Their $900 billion Tax Cut,” Tax Notes, 5 March 2001, 1274. 34. “Gulliver’s Tax Cut,” WSJ, 7 March 2001, A22. 35. Professor Hall made the comment at the annual meeting of the American Economic Association in January 2001. Quoted in Steve Liesman, “Bush’s $1.6 Trillion Tax Cut May Not Deliver Right Fix,” WSJ, 8 January 2001, A2. 250

Notes to Pages 126–132 36. This is a major complaint of liberal economist Paul Krugman, who derides the 2001 tax cut as basically the wrong medicine at the wrong time, administered in too great a dosage. See Paul Krugman, Fuzzy Math: The Essential Guide to the Bush Tax Plan (New York: W.W. Norton, 2001). 37. Quoted in Greg Hitt, “House Republicans Move Forward with 2002 Budget, Unveil Tax Cuts,” WSJ, 22 March 2001, A24. 38. A good analysis of why the 32 conservative House Democrats (most of whom are from the South) known as the Blue Dogs have generally failed to support the entire Bush agenda is Michael Crowley, “Wag the Dog,” The New Republic, 20 August 2001, 10. 39. Quoted in Greg Hitt and Jeanne Cummings, “Budget Compromise Calls for 4.9% Spending Rise,” WSJ, 3 May 2001, A3. 40. For a description of the “strange” and complicated provisions in the Senate bill, see Martin A. Sullivan, “Ten Strange Provisions in the Senate Bill,” Tax Notes, 21 May 2001, 1197. 41. Christopher Bergin, “Several Ways to Spell RELIEF,” Tax Notes, 21 May 2001, 1189. 42. Joint Committee on Taxation, Estimated Budget Effects of the Conference Agreement for H.R. 1836 (JCX-51-01), 26 May 2001. In fact, with expected budget surpluses coming up short during the summer, Treasury was forced to borrow $38 billion (through issuing marketable debt) to pay the “tax rebate”— really, an advance payment of the 2001 rate reduction for individuals. See Amy Hamilton, “Treasury Borrows $38 Billion to Pay for Tax Rebate,” Tax Notes, 6 August 2001, 716. 43. Ibid. 44. Some liberal Democrats foolishly objected to the phaseout of these illconceived limits on personal exemptions and miscellaneous itemized deductions. For example, Robert McIntyre of the liberal, pro-labor organization Citizens for Tax Justice (CTJ) complains that the elimination of the phaseout is really a “back-door” tax cut for wealthy taxpayers. “The 2001 Tax Bill,” CTJ Update, August 2001. This completely ignores the fact that these limits on the tax benefits allowed to the wealthy were enacted in 1990 and 1993 in lieu of rate increases. 45. For a description of the sunset provision, see Joint Committee on Taxation, Summary of Provisions Contained in the Conference Agreement for H.R. 1836, the Economic Growth and Tax Relief Reconciliation Act of 2001 (JCX-50-01), 26 May 2001. See also Mac Campbell, “The 2001 Tax Cuts ‘Sunset,’ ” Tax Notes, 22 April 2002, 623. The Byrd rule is discussed further in chapter 8 in Note 55. 46. Under the agreement that Trent Lott struck with Senate Democrats in January 2001, it was already agreed that Tom Daschle would become majority leader in the event that the balance of power shifted in favor of the Democrats. Of course, everyone was thinking of the departure of Strom Thurmond from the Senate, not Jim Jeffords from the GOP, when they reached that agreement. 47. The Washington Times, 23 July 2001, A19. 251

Notes to Pages 132–139 48. Congressional Budget Office, The Budget and Economic Outlook: An Update (Washington, D.C.: GPO, August 2001). 49. Ibid., Monthly Budget Review: Fiscal Year 2001 (Washington, D.C.: GPO, 26 September 2001). 50. According to a report by the pro-Labor public interest group Citizens for Tax Justice, IBM would get a refund of $1.4 billion, Ford would get $1.0 billion, and General Motors would get $833 million under this proposal. See “House GOP ‘Stimulus’ Bill Offers 16 Large, Low-Tax Corporations $7.4 Billion in Instant Tax Rebates,” CTJ Update, 26 October 2001. 51. The GOP bill is described in Joint Committee on Taxation, Description of the Economic Security and Recovery Act of 2001 (JCX-69-01) 11 October 2001; see also Warren Rojas, Heidi Glenn, and Patti Mohr, “House to Move $160 Billion GOP Stimulus Tax Package,” Tax Notes, 15 October 2001, 303. 52. An excellent discussion of the problems associated with using public investment as an economic stimulus is found in Martin A. Sullivan, “Not Very Stimulating: Congress Fiddles, While Economy Burns,” Tax Notes, 5 November 2001, 732. 53. Quoted in “No Way to Boost the Economy,” NYT, 20 October 2001, A22. O’Neill’s comment drew sharp reprimands from antitax conservatives in the House, as well as rebukes from the White House. 54. See Bruce Bartlett, “Tax Rebates Won’t Stimulate the Economy,” WSJ, 1 November 2001, A20. 55. See Patti Mohr, “House Barely Approves $160 billion Economic Stimulus,” Tax Notes, 29, October 2001, 586. 56. See Warren Rojas, “Senate Taxwriters Float Dueling Stimulus Proposals,” Tax Notes, 29 October 2001, 583. 57. Quoted in Shailagh Murray, “House Passes GOP Stimulus Plan and Senators Explore Alternatives,” WSJ, 25 October 2001, A2. 58. Quoted in Jim VandeHei, “ Bush Asks Congress for More Tax Cuts to Spur Economy,” WSJ, 1 November 2001, A2. 59. Joint Committee on Taxation, Estimated Revenue Effects of H.R. 3090, the Economic Recovery and Assistance for American Workers Act of 2001, as Ordered Reported by the Finance Committee on November 8, 2001 (JCX-81-01), 9 November 2001. 60. Congressional Budget Office, Economic Stimulus: Evaluating Proposed Changes in Tax Policy (Washington, D.C.: January 2002). 61. Joint Committee on Taxation, Estimated Revenue Effects of the “Job Creation and Workers Assistance Act of 2002,” (JCX-13-02), 6 March 2002. 6

GOP Campaign to Kill the “Death Tax”

1. The Economic Growth and Tax Relief Reconciliation Act of 2001 accelerated the increase in the exemption, which rose to $1 million in 2002. 252

Notes to Pages 139–144 2. In fact, very few estates make use of any of these special provisions for owners of farms and small businesses. In 1999, only 141 estates claimed the special-use valuation, while only 524 made use of the reduced interest and installment payment method. Joint Committee on Taxation, Description and Analysis of Present Law and Proposals Relating to Federal Estate and Gift Taxation (JCX-14-01), 14 March 2001, Table 6a (“Estate Tax Returns Filed in 1999 Utilizing Provisions to Benefit Small and Family-Owned Businesses”). 3. For 1999, 804 estates claimed the new exemption—more than most would have predicted, but hardly a very extensive use of the provision. Ibid. 4. In fact, there are very few full-time farms that are ever subject to the estate tax. This is because farmers already enjoy special favorable treatment under several provisions of the estate tax. Preliminary IRS figures show that in 1999, of the 49,870 estates that were subject to estate tax, only 6,216 (or 12.5 percent) included any farm assets. Of these, only 1,222 (or 2.5 percent) were taxable on account of the farm assets. In other words, most were wealthy individuals (gentlemen farmers) who were already subject to the estate tax and also owned some real estate and farm assets. A good account of how politicians exploit the issue by playing to the fears of farmers, see David Cay Johnston, “Farmers’ Fears Reflect Myths and Confusion on Estate Tax,” NYT, 8 April 2001, 1. 5. Quoted in Ryan J. Donmoyer, ‘Death Tax’ Death Warrant Signed by House,” Tax Notes, 12 June 2000, 1431. 6. Press release of Senator Trent Lott quoted in “Lott Would Slay Estate Tax ‘Monster,’ ” Tax Notes, 24 May 1997, 1564. 7. Act of July 6, 1797, 1 Stat. 527. 8. For a brief description of the Stamp Act of July 6, 1797, see John R. Luckey, “A History of Federal Estate, Gift, and Generation-Skipping Taxes,” (95– 444A) (Washington, D.C.: Congressional Research Service, 16 March 1995), 2–3. 9. Act of June 30, 1802, 2 Stat. 148. 10. Act of July 1, 1862, 12 Stat. 432, 483. Legislative history is found at Cong. Globe, 37th Cong., 2nd Sess. (1862) 1534. 11. Act of July 30, 1864, 13 Stat. 285. 12. Act of July 15, 1870, 16 Stat. 256. 13. Act of June 4, 1898, 30 Stat. 448. 14. The estate tax was repealed pursuant to the Act of April 12, 1902, 32 Stat. 92. 15. President Theodore Roosevelt in 1907, referring to his proposed federal inheritance tax, quoted in Messages and Papers of the Presidents, vol. 14 (New York: Bureau of National Literature, 1916), 7084. 16. Roy G. Blakely and Gladys C. Blakely, The Federal Income Tax (New York: Longmans, Green & Co., 1940), 153. It has been calculated that war expenditures from 1917 to 1920 were approximately $38 billion. Charles Gilbert, 253

Notes to Pages 144 –151 American Financing of World War I (Westport, Conn.: Greenwood Publishing Co., 1970), 69. 17. Act of March 3, 1917, 39 Stat. 1000. 18. The credit is to be phased out over four years under the 2001 tax act, and then reappears for decedents dying after 2010. 19. Revenue Act of 1940, 54 Stat. 516. 20. Act of September 20, 1941, 55 Stat. 687. 21. For a survey of the wealth transfer tax systems of 28 countries, see Joint Committee on Taxation, Issues Presented by Proposals to Modify the Tax Treatment of Expatriation (JCS-17-95), 1 June 1995, C1–C17; see also Joint Committee on Taxation, Description and Analysis of Present Law and Proposals Relating to Federal Estate and Gift Taxation (JCX-14-01), 14 March 2001, 26–30 (“Comparison of Transfer Taxation in the United States and Other Countries”). 22. Michael J. Graetz, “To Praise the Estate Tax, Not to Bury It.” Yale Law Journal 93 (1983): 259. 23. See e.g., James R. Repetti, “Democracy, Taxes and Wealth,” New York University Law Review 76 (2001): 825. 24. The basis of assets are stepped up at death under IRC section 1014. 25. IRC section 102: “Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.” 26. Edward J. McCaffery, “The Political Liberal Case Against the Estate Tax,” Philosophy & Public Affairs 23 (Fall 1994): 281; “The Uneasy Case for Wealth Transfer Taxation,” Yale Law Journal 104 (1994): 283; “Grave Robbers: The Moral Case Against the Death Tax,” Tax Notes, 13 December 1999, 1429. 27. John Rawls, A Theory of Justice (Cambridge: Harvard University Press, 1971), 277. 28. Ibid., 278. 29. McCaffery, “The Uneasy Case for Wealth Transfer Taxation,” 334. 30. For estates between $10 million and $17.18 million, a 5 percent surtax kicked in to eliminate the benefits of the graduated rate structure, thereby imposing a marginal rate of 60 percent at these levels. 31. U.S. Department of Treasury, Financial Management Service, Monthly Treasury Statement, December 2000, Table 3, “Summary of Outlays and Receipts of U.S. Government.” The IRS reports that for 1999, 116,500 estate tax returns were filed, including 5,200 for estates worth $5 million or more. 32. See e.g., Alan Reynolds, “Death and Taxes,” WSJ, 1 May 1997, A18.; William W. Beach, “The Case for Repealing the Estate Tax,” Heritage Foundation Backgrounder, 21 August 1996, 1–29. 33. This negative assessment of the economic inefficiency of the estate tax is supported by the findings of the Joint Economic Committee in its study, “The Economics of the Estate Tax,” (Washington, D.C.: U.S. Government, December 1998) (concluding that “the estate tax generates costs to taxpayers, the economy and the environment that far exceed any potential benefits that it might arguably 254

Notes to Pages 151–156 produce.”). See also Bruce Bartlett, “The End of the Estate Tax?” Tax Notes, 7 July 1999, 105: “The estate and gift tax . . . wastes resources, it discourages work, saving, and investment, and it does virtually nothing to equalize the distribution of wealth. In short, the estate and gift tax is a failure. It should be abolished.” 34. For example, see the excellent and provocative study by Charles Davenport and Jay A. Soled, “Enlivening the Death-Tax Death-Talk,” Tax Notes, 26 July 1999, 591. 35. Joint Committee on Taxation, Description and Analysis of Proposals Relating to Estate and Gift Taxation (JCS-7–97), 8 April 1997, Table 5, “Projections of Taxable Estates and Receipts from Federal Estate, Gift, and Generation-Skipping Transfer Taxes, 1997–2007.” 36. Memo to John Buckley from Lindy Paull, Chief of Staff, Joint Committee on Taxation, 26 March 2001. Similar warnings of the risks to the income tax from repealing the gift tax were made by John Buckley, chief Democratic Tax Counsel for the Ways and Means Committee. John Buckley, “Transfer Tax Repeal Proposals: Implications for the Income Tax,” Tax Notes, 22 January 2001, 539. See also Jonathan G. Blattmachr and Mitchell N. Gans, “Wealth Transfer Tax Repeal: Some Thoughts on Policy and Planning,” Tax Notes, 15 January 2001, 393. 37. An example of such treatment by the press is a series of front-page stories that ran in the New York Times in 1996. See Christopher Drew and David Cay Johnson, “For Wealthy Americans, Death Is More Certain Than Taxes,” NYT, 22 December 1996, 1. 38. The basis carryover provision in the Death Tax Elimination Act, with all its loopholes and exemptions, is soundly criticized in Joseph M. Dodge, “What’s Wrong with Carryover Basis Under H.R. 8,” Tax Notes, 7 May 2001, 961. 39. A full defense of a deemed realization system in which gains are taxed at death is found in Joseph M. Dodge, “A Deemed Realization Approach is Superior to Carryover Basis (and Avoids Most of the Problems of the Estate and Gift Tax),” Tax Law Review (Summer 2001): 421. 40. In addition, rules to prevent the use of generation-skipping trusts would need be employed. Such rules are described in See Stephen Vasek, “Death Tax Repeal: Alternative Reform Proposals,” Tax Notes, 13 August 2001, 955, 962. 41. Lawrence Zelnick, “Taxing Gains at Death,” Vanderbilt Law Reveiw 46 (1993): 361, 416. 42. The two options of adopting a tax on gains at death or a carryover basis rule are examined in Karen C. Burke and Grayson M.P. McCouch, “Death Without Taxes?” Virginia Tax Review 20 (2001): 499. 43. IRC section 102. 44. William G. Gale and Joel B. Slemrod, “A Matter of Life and Death: Reassessing the Estate and Gift Tax,” Tax Notes, 14 August 2000, 927. This approach to reform, as well as many other proposals, is evaluated by the Tax Division of the American Institute of Certified Public Accountants in its recent 255

Notes to Pages 156–162 report, Reform of the Estate and Gift Tax System reprinted in Tax Notes, 9 April 2001, 307–35. 45. Thomas Barthold and Robert Plotnick, “Estate Taxation and Other Determinants of Charitable Bequests,” National Tax Journal 37 (1984): 225. The findings of their research fail to confirm that higher estate tax rate encourages larger charitable bequests. 46. Most studies have concluded that tax deductions for charitable bequests encourage the rate of charitable giving. See e.g., Charles T. Clotfelter, Federal Tax Policy and Charitable Giving (Chicago: University of Chicago Press, 1985). A more recent survey of the literature supporting this conclusion is David Joulfaian, “Estate Taxes and Charitable Bequests by the Wealthy,” National Tax Journal 53 (September 2000): 743. See also Gerald E. Auten, Charles T. Clotfelter, and Richard L. Schmalbeck, “Taxes and Philanthropy Among the Wealthy,” Office of Tax Policy Research, Ann Arbor, University of Michigan, Working Paper No. 98–15 (10 December 1997). 47. Calvin Trillin, “On the Gradual End of the Estate Tax,” The Nation, 18 June 2001, 6. 7

The Great Corporate Tax Giveaway

1. The passive activity loss rules are found in IRC section 469. 2. Notice 99–59, 1999–2 C.B. 761 (27 December 1999). 3. Quoted in John D. McKinnon, “How New Tax Shelter Promised Big Savings But Finally Fell Apart,” WSJ, 21 August 2000, A1. 4. Notice 2000– 44, 2000–36 I.R.B. 255 (5 September 2000). 5. ACM Partnership v. Commissioner, 157 F.3rd 231 (3rd Cir. 1998), aff ’ing in part and re’vg in part T.C. Memo. 1997–115, cert denied 119 S.Ct. 1251 (1999). 6. Merrill Lynch & Co. itself reached a settlement with the IRS in August 2001, making a “substantial payment” in connection with its role in marketing these “sham” tax shelters to clients in the 1990s. See Randall Smith and John McKinnon, “IRS, Merrill Reach Pact on Shelters,” WSJ, 29 August 2001, C1. However, the government suffered a loss litigating a very similar case in October 2001. See Boca Investerings Partnership v. United States, 167 F. Supp. 2d 298 (D. D.C. 5 October 2001). 7. Compaq Computer Corp. v. Commissioner, 113 T.C. No. 17 (1999). 8. Compaq Computer Corp. v. Commissioner, 277 F. 3d 778 (28 December 2001). 9. Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. No. 21 (1999). 10. American Electric Power Inc. v. United States, 2001 U.S. Dist. LEXIS 1705 (20 February 2001). 11. The testimony is found in Joint Committee on Taxation, Testimony of the Staff of the Joint Committee on Taxation Before the Committee on Ways and Means (JCX-82-99), 10 November 1999. 12. The number of IRS employees has gradually declined in past years. 256

Notes to Pages 162–166 The IRS had a peak number of 116,673 employees in 1992. By 2000, the number was down to 96,995. IRS audits of corporation and individuals has also dropped significantly throughout the same period. 13. Saba Partnership v. Commissioner, T.C. Memo. 1999–359. 14. Rev. Rul. 99–14, 1999–1 C.B. 3 (29 March 1999). 15. Martin A. Sullivan, “One Shelter at a Time?” Tax Notes, 6 December 1999, 1226. 16. One recent evaluation of the problem and plan for dealing with corporate tax shelters through legislation similar to what was passed by Congress in 1986 is found in George K. Yin, “Getting Serious About Corporate Tax Shelters: Taking a Lesson from History,” SMU L. Rev. 54 (2001): 209. 17. Quoted in Tax Notes, 6 December 1999, 1226. 18. Quoted in Christopher Bergin, Maggie Richardson, and Sheryl Stratton, “Summers Delivers Sharp Words on Corporate Shelters,” Tax Notes, 20 November 2000, 991. 19. IRS Temporary and Proposed Regulations on Corporate Tax Shelter Registration, REG-110311–98; IRS Temporary and Proposed Regulations Requiring Corporations to Disclose Tax Shelters, REG-103735–00. For a discussion of the difficulties in drafting such regulations, see Lee A. Sheppard, “Drafting Economic Substance,” Tax Notes, 3 September 2001, 1258. For a summary of the new regulations, see Thomas M. Cryan, John R. Keenan, and David B. Auclair, “A Guide to the New Corporate Tax Shelter Regulations,” Tax Notes, 10 September 2001, 1449. 20. IRS List of Tax Shelters, Notice 2000–15, 2000–1 C.B. 826 (20 March 2000). 21. Reported in Sheryl Stratton, “IRS Pursues All Fronts in War on Abusive Tax Shelters,” Tax Notes, 22 January 2001, 436. 22. IRS Temporary and Proposed Regulations Under Circular 230, REG-111835–99. 23. An assessment of the need for new penalties for those who claim deductions from tax shelter deals is found in Lee A. Sheppard, “Constructive Thinking About Tax Shelter Penalties,” Tax Notes, 20 August 2001, 1013. 24. See John D. McKinnon, “IRS Says About 25 Companies Evaded $4 Billion in Taxes in Improper Shelters,” WSJ, 2 April 2001, A2; Sheryl Stratton, “IRS Tax Shelter Offices Geared Up to Handle More Disclosure Statements,” Tax Notes, 9 April 2001, 213. 25. John D. McKinnon, “How New Tax Shelter Promised Big Savings But Finally Fell Apart,” WSJ, 21 August 2000, A1. 26. In July 2001, Bush’s nominee for IRS Chief Counsel, B. John Williams, a former judge on the U.S. Tax Court, won a case for Rite-Aid Corp. in the U.S. Court of Appeals for the Federal Circuit that could be useful for corporate tax shelters. See John D. McKinnon, “Nominee for IRS Legal Job Wins Ruling That May Hurt Tax-Shelter Crackdown,” WSJ, 10 July 2001, A2. 257

Notes to Pages 167–173 27. See “Interview With Mark Weinberger,” Newsletter (ABA Section of Taxation), 20 (Summer 2001): 23, 26. Barely a year in his position, Weinberger announced his resignation and returned to the private sector. 28. Quoted in Ryan J. Donmoyer, “GOP Leadership: Shelter Problem, What Shelter Problem?” Tax Notes, 21 February 2000, 1039. 29. Martin A. Sullivan, “A Revenue Estimate for Corporate Tax Shelters,” Tax Notes, 22 November 1999, 981. 30. Department of the Treasury, Financial Management Service, “Monthly Treasury Statement,” September 1999. 31. Figures compiled in Martin A. Sullivan, “Corporate Tax Refunds Are Surging,” Tax Notes, 21 February 2000, 1040.

8

The Politics of the Surplus

1. U.S. Treasury Department, Final Monthly Treasury Statement of Receipts and Outlays of the United States Government for Fiscal Year 1998. 2. Congressional Budget Office, Economic and Budget Outlook: Fiscal Years 2000–2009 (Washington, D.C.: GPO, January 1999). 3. Ibid., The Budget and Economic Outlook: Fiscal Years 2002–2011 (Washington, D.C.: GPO, January 2001). It should be noted that on account of the decline in the economy and stock market in the first quarter of 2001, most Wall Street forecasters were already reducing their estimates of the fiscal year 2001 surplus to much lower figures than the $281 billion that CBO still predicted. 4. CBO’s 10-year estimates assume that current economic conditions will persist during the first two years of the period and take into account the “possibility of booms and recessions” during the final eight years of the period. However, current economic trends are incorporated into long-term projections. 5. For an account of the “generosity” of the Appropriations Committee, see David Rogers, “House GOP Undoes Bush Budget Cuts: Appropriations Panel Adds Funds to Energy, Water and Farm Bills,” WSJ, 7 June 2001, A24. 6. For a discussion of the problems and difficulties that affect long-term economic and budget forecasts from CBO and OMB, see Rudolph G. Penner, Errors in Budget Forecasting (Washington, D.C.: Urban Institute Press, 2001). 7. William G. Gale and Alan J. Auerbach, “Tax Cuts and the Budget,” Tax Notes, 26 March 2001, 1869, 1872. 8. For an interesting and timely description of the important role of economic forecasters in CBO in shaping President Bush’s 2000 political campaign, see Bob Davis, “President Owes a Lot to Two Economists You Never Heard Of: Bush’s Debt to CBO Shows Impact of the Forecasts from an Obscure Agency,” WSJ, 27 February 2001, A1. 9. Senator Pete Domenici (R-N.M.), quoted in Tax Notes, 5 February 2001, 698. 258

Notes to Pages 174 –178 10. These lower surpluses would still amount to 1.5 percent to 2.2 percent of GDP during the first five years of the baseline, and then rise to 3 percent of GDP by the end of the 10-year period. Congressional Budget Office, The Budget and Economic Outlook: An Update (Washington, D.C.: GPO, August 2001). 11. The GAO puts the number at $3 trillion. United States General Accounting Office, “Social Security: Different Approaches for Addressing Program Solvency,” (GAO/HEHS-98–33) Washington, D.C.: U.S. General Accounting Office, July 1998. A more recent estimate is that there is a $11.7 trillion unfunded liability for Social Security benefits that have already accrued. See Jonathan Barry Forman, “Thoughts on Saving Social Security,” Tax Notes, 3 September 2001, 1357. 12. Social Security and Medicare Board of Trustees, Status of the Social Security and Medicare Programs: A Summary of the 2001 Annual Reports (19 March 2001). 13. Paul Krugman, Fuzzy Math: The Essential Guide to the Bush Tax Plan (New York: W.W. Norton, 2001), 49. 14. Office of Management and Budget, The Budget for Fiscal Year 2002, Table S-17 “Baseline Category Totals.” 15. President Roosevelt allegedly set the program up this way on purpose. “We put those payroll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions. . . . With those taxes in there, no damm politician can ever scrap my social security program.” Franklin D. Roosevelt quoted in Arthur M. Schlesinger, Jr. The Coming of the New Deal (Boston: Houghton Mifflin Co., 1958), 308–09. 16. For a discussion of the problems of budgeting for entitlement programs such as Social Security, see Joseph White, “Budgeting for Entitlements,” in Handbook of Government Budgeting, Roy T. Meyers, ed. (San Francisco: JosseyBass Publishers, 1999), 678–98. 17. Ronald F. King, Budgeting Entitlements: The Politics of Food Stamps (Washington, D.C.: Georgetown University Press, 2000), 4. 18. Politicians have even been afraid to reduce benefits indirectly by correcting the computation for the annual cost of living adjustment (COLA), which most economists believe overstates inflation and provides too great an increase in benefits. 19. The best account of the intergenerational redistributive effect of Social Security is found in Laurence J. Kotlikoff, Generational Accounting (New York: Free Press, 1992); see also C. Eugene Steuerle and Jon M. Bakija, Retooling Social Security for the 21st Century: Right and Wrong Approaches to Reform (Washington, D.C.: Urban Institute Press, 1994), 106–13 (summarizing the conclusions of the authors with respect to inter- and intra-generational transfer effects of the Social Security system). 20. For a simple description of the fairly complicated formula for computing benefits based on a worker’s earnings history, see Daniel Shaviro, Making Sense of Social Security Reform (Chicago: University of Chicago Press, 2000), 10–23. 259

Notes to Pages 179–180 21. “Investing Social Security’s reserves in a broad mix of private and public assets would strengthen the programs’ financial position substantially. But additional measures—benefit cuts or tax increases—are required to fully address the programs’ long-run imbalance.” Henry J. Aaron and Robert D. Reischauer, Countdown to Reform: The Great Social Security Debate (New York: Century Foundation Press, 1998), 13–14. Federal Reserve Chairman Alan Greenspan recently expressed his view that any “permanent” solution to Social Security will require either benefit cuts or tax increases. Martin Crutsinger, “Greenspan Says Social Security to Need Tax Increase or Benefit Cuts,” Philadelphia Inquirer, 29 January 1999, A2. The difficulty of “fixing” Social Security with tax increases or cuts in benefits while preserving the overall (albeit ambiguous) features of the Social Security program (such as the progressivity of the distribution of benefits) is the central theme of one of the best accounts of reform policy, Steuerle and Bakija, Retooling Social Security for the 21st Century. 22. The idea is still pretty popular with Republicans, and as late as summer 2000, there was widespread support for the idea. A poll conducted for the Associated Press at that time found that respondents favored the idea by a 2 to 1 ratio. However, after the minicrash of the stock market in early 2001, popular opinion shifted. Only 49 percent of respondents in a similar poll expressed support, while 44 percent opposed investing Social Security funds in the stock market. See Will Lester, “Falling Stocks Tarnish Social Security Plan,” Philadelphia Inquirer, 31 March 2001, A4. 23. The difficulties in finding alternative means for financing Social Security are discussed in greater detail in Steuerle and Bakija, Retooling Social Security for the 21st Century, 157–76. 24. The day after the President’s State of the Union address, speaking before the House Ways and Means Committee, Alan Greenspan, chairman of the Federal Reserve Board, expressed his reservations about the President’s plan for the government to enter the private securities markets in such a big way. David Wessel, “Greenspan Frets Over Outlook for Stocks: Fed Chair Opposes Plan by Clinton to Invest Part of Social Security Fund,” WSJ, 21 January 1999, A3. 25. William Jefferson Clinton, “Address Before a Joint Session of the Congress on the State of the Union,” 19 January 1999. 26. For a biting critique of the shoddy accounting behind this “budget sham,” see Martin Feldstein, “Clinton’s Social Security Sham,” WSJ, 1 February 1999, A20; see also Matthew Miller, “Slick: Saving Social Security with a Pencil,” The New Republic, 15 February 1999, 14 –15 (describing Clinton’s plan as a double-counting “accounting scam” ); Gene Steuerle, “ ‘Spending’ the Surplus: Counting the Ways,” Tax Notes, 1 February 1999, 715 (“Essentially, the administration has proposed to run a non-Social Security deficit of about $2 trillion to be able to finance both the additional transfer to Social Security and its other spending and tax proposals.”); but c.f. Henry J. Aaron, “The Phony Issue of Double-Counting,” Tax Notes, 1 February 1999, 717 (concluding that “the 260

Notes to Pages 180–184 double-counting issue is bogus”). Aaron’s point is that while the President’s plan does in a sense “double-count’ that portion of the surplus to be “dedicated” to Social Security, and accordingly, will result in an increased deficit under “traditional unified budget accounting” rules, this “extra” contribution to Social Security will reduce by an equal amount the federal government’s “shadow debt” (e.g., the government’s unfunded liability for future Social Security and Medicare payments in excess of the present value of future payroll taxes at current rates). 27. Congressional Budget Office, Economic and Budget Outlook: Fiscal Years 2000–2009 (Washington, D.C.: GPO, January 1999). The January 1999 prediction of an on-budget surplus in 2001 revised CBO’s earlier prediction that such would not be realized until the year 2005. 28. Herbert Stein, “Why I Am a Republican,” WSJ, 29 December 1998, A12. Stein’s last book, What I Think, (Washington, D.C.: American Enterprise Institute, 1998), is a must-read—notwithstanding its pompous title. For Stein’s reasoned analysis of the various arguments over what to do with the projected surpluses, see “At Sea with Surpluses,” WSJ, 19 May 1998, A22. Sadly, with Stein’s recent passing, we are deprived of his wit and intelligence, and the national debate over the budget and surplus was greatly diminished. 29. In calendar year 1997, interest earnings on the invested assets of the combined OASI and DI Trust Funds totaled $43.8 billion, representing an effective annual rate of 7.5 percent. 1998 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors and Disability Insurance Trust Funds, 28 April 1998. That is a whole lot better than the rate of return that this author saw in the stock market in 2000, 2001, and 2002. 30. Among those academics who have championed privatization are economists Peter Ferrara of the Cato Institute, Milton Friedman of the University of Chicago, Laurence Kotlikoff of Boston University, and Jeffrey Sachs of Harvard University. A good summary of the literature and issues over privatization is found in Shaviro, Making Sense of Social Security Reform, 126– 45. 31. For a summary of the positions of the members of the commission regarding privatization of Social Security, see Jackie Calmes, “Bush Social Security Panel Doesn’t Fear Painful Solutions,” WSJ, 10 May 2001, A20. 32. Martin Feldstein, “Toward a Reform of Social Security,” The Public Interest 40 (1975): 75. 33. Martin Feldstein, “Don’t Waste the Budget Surplus,” WSJ, 4 November 1997, A22. 34. Jonathan Chait, “Security Risk,” The New Republic, 18 January 1999, 24. 35. Specifics of the plan are hard to come by, even in the Treasury’s 198– page description of the President’s revenue proposals—the so-called Green Book. Department of the Treasury, General Explanation of the Administration’s Revenue Proposals (Washington, D.C.: U.S. Department of the Treasury, February 1999). The day the President’s budget was released, Deputy Treasury Secretary Lawrence Summers was quoted as saying that the “vast majority” of Ameri261

Notes to Pages 184 –187 cans would be affected by the USA Accounts. Tom Herman and Karen Hure, “New Retirement Plans, Tax Breaks Are Offered in Clinton’s Proposal,” WSJ, 2 February 1999, C1. 36. Christopher Bergin, “The Sounds of Cheers and Silence,” Tax Notes, 25 January 1999, 397. 37. Leslie Wayne, “U.S.A. Accounts Are New Volley in Retirement Savings Debate,” NYT, 24 January 1999, sec. 3, 4. 38. Some have expressed fear that the government would exert too much influence over the stock market generally, and particular corporations in which Social Security assets are invested. Free-market economist Milton Friedman has even suggested that government investment of the trust funds in the stock market would lead to “socialism.” Milton Friedman, “Social Security Socialism,” WSJ, 26 January 1999, A18. 39. Lawrence S. Seidman, Funding Social Security: A Strategic Alternative (New York: Cambridge University Press, 1999), 10. 40. Titles 9 and 10 of the Omnibus Budget Reconciliation Act of 1987, Pub. L. No. 100–203, 101 Stat. 1330–282. 41. Aaron B. Wildavsky and Joseph White, The Deficit and the Public Interest: The Search for Responsible Budgeting in the 1980s (Berkeley and Los Angeles: University of California Press, 1989), 431. 42. Allen Schick, The Federal Budget: Politics, Policy, Process (Washington, D.C.: Brookings Institution Press, 1995), 39. 43. “[N]ew tax provisions or entitlement programs can be drafted so that most of the revenue is lost outside the budget window. Proponents can therefore escape some of the discipline of offset requirements.” Elizabeth Garrett, “Rethinking the Structures of Decisionmaking in the Federal Budget Process,” Harvard Journal on Legislation 35 (Summer 1998): 403. 44. OMB’s annual fiscal-year baseline is determinative for purposes of whether sequestration is triggered under the PAYGO rule, discussed further below. Congress relies upon revenue estimates from the Joint Committee on Taxation (JCT) when considering new legislation. CBO is responsible for estimating future revenues under current law as part of its ten-year baseline budget projections. If legislation affecting revenues is enacted, JCT estimates the revenue effects and CBO incorporates those estimates into its next baseline revenue projection. 45. Pub. L. No. 99–514, 100 Stat. 2085. 46. In fact, the distributional effect of TRA was slightly progressive if corporate taxation is distributed to high-income taxpayers. Henry J. Aaron, “The Impossible Dream Comes True,” in Tax Reform and the U.S. Economy, ed. Joseph A. Pechman, (Washington, D.C.: Brookings Institution Press, 1987), 10. 47. C. Eugene Steuerle, The Tax Decade: How Taxes Came to Dominate the Public Agenda (Washington, D.C.: Urban Institute Press, 1992), 107. 48. 2 U.S.C.A. sec. 601 et seq. (Title 6, “Budget Agreement Enforcement Provision”). 262

Notes to Pages 188–190 49. Congressional Budget and Impoundment Control Act of 1974, Pub. L. No. 93– 433. 50. See 2 U.S.C.A. secs. 633(c), (f ), and 902. 51. 2 U.S.C.A. sec. 601 et seq. (Title 6, “Budget Agreement Enforcement Provision”). The Budget Enforcement Act of 1990 also provided for adjustable spending caps and caps on discretionary spending. These are easily avoided, as witnessed by the President’s fiscal year 2000 budget. See David Wessel, “How Budget Maneuvers Around Spending Caps,” WSJ, 2 February 1999, A8. 52. The wisdom of using cuts to Social Security and Medicare to finance new tax expenditures has been questioned. See Elizabeth Garrett, “Harnessing Politics: The Dynamics of Offset Requirements in the Tax Legislation Process,” University of Chicago Law Review 65 (Spring 1998): 501, 514. 53. Garrett, “Harnessing Politics,” 504. 54. 2 U.S.C.A. Section 604(a). 55. The Byrd rule is described in greater detail in Allen Schick, The Federal Budget: Politics, Policy, Process (Washington, D.C.: Brookings Institution, 1995), 85. See also Robert Keith, “The Senate’s Byrd Rule Against Extraneous Matter in Reconciliation Measures,” CRS Report for Congress, 97–688 GOV (updated 9 September 1998); Christopher Georges, “Byrd Procedural Rule Is Threatening to Derail Substantial Portions of the Republican Agenda,” WSJ, 8 November 1995, A22. 56. For an account of Kasich’s position, see Jonathan Chait, “Honest John,” The New Republic, 13 July 1998, 22–25. 57. Jacob M. Schlesinger, “Senate Leaders Call for Easing of Rules Limiting Tax Cuts and Spending Increases,” WSJ, 7 December 1998, A3. 58. Domenici’s position is discussed in Greg Hitt, “Surplus Converts Chief GOP Deficit Hawk to Tax Cuts,” WSJ, 1 February 1999, A22; Heidi Glenn, “Senate Budget Committee to Look at Pay-As-You-Go Rules,” Tax Notes, 28 December 1998, 1593. Domenici initially argued that the rules already allow an on-budget surplus to be used for tax reduction—a position flatly disputed by departing CBO director June O’Neill. See Heidi Glenn and Daniel Tyson, “Clinton Throws Out First Tax Cut Chip,” Tax Notes, 11 January 1999, 161. In late January, Domenici introduced legislation that would put Congress on a twoyear budget cycle as well as permit on-budget surpluses to finance tax cuts or direct spending increases. 59. “Senate Budget Dems Urge Leaving Pay-As-You-Go Rules Unchanged,” Tax Notes, 28 December 1998, 1647. 60. In fact, deficit spending may be exactly what is called for under certain economic conditions—such as the period of mild recession experienced in early 2001. Overall, there is an unsupportable preference for “balanced” budgets in American politics. Ignoring that the whole question of whether the budget is balanced, in deficit, or in surplus is highly arbitrary and depends on the set of accounting rules used, there simply is no reason why the government ought to 263

Notes to Pages 190–195 spend exactly what it collects in any given year—no more and no less. For an interesting account of the history, rhetoric, and politics behind balanced budgets, see James D. Savage, Balanced Budgets and American Politics (Ithaca, N.Y.: Cornell University Press, 1988). 61. Even the most obstinate supply-sider, Jude Wanniski, once acknowledged that some level of taxation and public spending is necessary to achieve the optimal level of desired public goods and services. Jude Wanniski, “Tax Revenues and the Laffer Curve,” The Public Interest (Winter 1978), 4 –5. 62. Quoted in John H. Makin and Norman J. Ornstein, Debt and Taxes (New York: Random House, 1994), 75. 63. Timothy J. Conlan, Margaret T. Wrightson, and David R. Beam, Taxing Choices: The Politics of Tax Reform (Washington, D.C.: Congressional Quarterly Press, 1990), 101. 64. Ibid., 234. 65. Prior to PAYGO, tax expenditures resulted in increasing deficits. As a result, there was increased pressure to raise marginal rates and eventually, increased pressure for “tax reform”—defined as stripping preferences out of the tax code. This has led some to speculate on the cyclical nature of tax reform. See Irene S. Rubin, The Politics of Public Budgeting: Getting and Spending, Borrowing and Balancing, 3rd ed. (Chatham, N.J.: Chatham House, 1997), 30. 66. The Social Security Domestic Employment Reform Act of 1994, H.R. 4278, Pub. L. No. 103–387, 108 Stat. 407. The bill raised the threshold for employer withholding from $50 per quarter to $1,000 and exempted altogether from Social Security taxation and coverage household workers under the age of eighteen whose primary occupation is not household employment. 67. Pub. L. No. 105–34, 111 Stat. 788. 68. Pub. L. No. 105–33, 111 Stat. 251. 69. Pub. L. No. 105–206, 112 Stat. 685. 70. See Greg Hitt, “Lawmakers Strike Deal on IRS Overhaul,” WSJ, 24 June 1998, A2. 71. Joint Committee on Taxation, Estimated Budget Effects of Internal Revenue Service Restructuring and Reform Act of 1998 (JCX-51-98), 24 June 1998. 72. House Ways and Means Committee member John Ensign (R-Nev.) was successful in slipping into the IRS restructuring bill a proposal that he had introduced in the House in May. That bill, the Worker Meal Fairness Act of 1998, was cosponsored in the House by Speaker Newt Gingrich (R-Ga.). For an account of Ensign’s lobbying, as well as the impact of the provision, see Amy Hamilton, “IRS Reform’s Flying Circus—Tales of One Last-Minute Change,” Tax Notes, 13 July 1998, 145–51; David Lupi-Sher, “Employer-Provided Meals— The Gaming Industry vs. the IRS,” Tax Notes, 28 December 1998, 1599. 73. Joint Committee on Taxation, Estimated Budget Effects of Internal Revenue Service Restructuring and Reform Act of 1998 (JCX-51-98), 24 June 1998.

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Notes to Pages 195–197 74. Tax-preferred retirement plans (employer plans, Keoghs, and IRAs) constitute the largest single tax expenditure, valued by the Treasury at $92.3 billion for fiscal year 1999. Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 1999–2003 (JCS-7–98), 14 December 1998. 75. Joint Committee on Taxation, Estimated Budget Effects of Internal Revenue Service Restructuring and Reform Act of 1998 (JCX-51-98), 24 June 1998. 76. Schmidt Baking Co. Inc., 107 T.C. 271 (1996). 77. Joint Committee on Taxation, Estimated Budget Effects of Internal Revenue Service Restructuring and Reform Act of 1998 (JCX-51-98), 24 June 1998. 78. The proposed credit would phase out for married taxpayers at income ranges between $110,000 and $130,000 and for single taxpayers between $75,000 and $95,000. Sandra Sobieraj, “Clinton to Propose Tax Credit for People Caring for Relatives in Need,” Philadelphia Inquirer, 4 January 1999, A5; Heidi Glenn and Daniel Tyson, “Clinton Throws Out First Tax Cut Chip,” Tax Notes, 11 January 1999, 159–162. 79. This proposal, estimated to raise some $600 million over five years, is described (not entirely accurately) in Jacob M. Schlesinger and Greg Hitt, “Clinton Wants to Tax Civil Damages,” WSJ, 1 February 1999, A3. The article fails to note that the section 162 deduction would be denied only for payments of punitive damages—not civil damages generally. Under IRC section 162(f ), a deduction is already denied for any expense incurred in carrying on a trade or business that is a “fine or similar penalty paid to a government for the violation of any law.” 80. Greg Hitt, “Tax Plan Targets Use of Offshore Losses: Clinton Considers Proposal To End Business Practice as Way to Find Revenue,” WSJ, 8 January 1999, A2. 81. These provisions include: taxation of the issuance of so-called tracking stock; modification of the antiabuse rules requiring the taxation of “boot” on the assumption of liabilities pursuant to the contribution of property for stock of a controlled corporation; and denying the benefit of the dividends received deduction for distributions on certain nonqualified preferred stock. These antiabuse provisions are described, respectively, in Department of the Treasury, General Explanation of the Administration’s Revenue Proposals (Washington, D.C.: U.S. Department of the Treasury, February 1999), 129, 117, 132. 82. The President’s fiscal year 2000 budget includes an antiabuse proposal that would provide taxpayers with a “fresh start” by eliminating tax attributes (including built-in losses) and marking-to-market bases when an entity or an asset becomes “relevant” for U.S. tax purposes. Department of the Treasury, General Explanation of the Administration’s Revenue Proposals (Washington, D.C.: U.S. Department of the Treasury, February 1999), 108.

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Bibliography Paul, Randolph E. Taxation in the United States. Boston: Little, Brown, 1954. Pechman, Joseph A. Federal Tax Policy, 5th ed. Washington, D.C.: Brookings Institution Press, 1987. Penner, Rudolph G. Errors in Budget Forecasting. Washington, D.C.: Urban Institute Press, 2001. Pollack, Sheldon D. The Failure of U.S. Tax Policy: Revenue and Politics. University Park: Penn State Press, 1996. Rae, Nicol C. Conservative Reformers: The Republican Freshmen and the Lessons of the 104th Congress. Armonk, N.Y.: M.E. Sharpe, 1998. ———. The Decline and Fall of the Liberal Republicans from 1952 to the Present. New York: Oxford University Press, 1989. ———, and Colton C. Campbell, eds. New Majority or Old Minority: The Impact of Republicans on Congress. Lanham, Md.: Rowman & Littlefield, 1999. Ratner, Sidney. American Taxation: Its History as a Social Force in Democracy. New York: W.W. Norton, 1942. Reinhard, David W. The Republican Right Since 1945. Lexington: University Press of Kentucky, 1983. Rubin, Irene S. The Politics of Public Budgeting: Getting and Spending, Borrowing and Balancing, 3d ed. Chatham, N.J.: Chatham House, 1997. Rutland, Robert Allen The Republicans: From Lincoln to Bush. Columbia, Mo.: University of Missouri Press, 1996. Savage, James D. Balanced Budgets and American Politics. Ithaca, N.Y.: Cornell University Press, 1988. Schick, Allen. The Federal Budget: Politics, Policy, Process. Washington, D.C.: Brookings Institution Press, 1995. Seidman, Laurence S. Funding Social Security: A Strategic Alternative. New York: Cambridge University Press, 1999. Shaviro, Daniel. Making Sense of Social Security Reform. Chicago: University of Chicago Press, 2000. Shuman, Howard E. Politics and the Budget: The Struggle Between the President and Congress. Engelwood Cliffs, N.J.: Prentice Hall, 1992. Skowronek, Stephen. Building a New American State: The Expansion of National Administrative Capacities, 1877–1920. New York: Cambridge University Press, 1982. Slemrod, Joel B., ed. Does Atlas Shrug? The Economic Consequences of Taxing the Rich. Cambridge: Harvard University Press and Russell Sage Foundation, 2000. Solow, Robert M. “Should We Pay the Debt?” The New York Review of Books XLVII, 5 October 2000: 7–9. Stanley, Robert. Dimensions of Law in the Service of Order: Origins of the Federal Income Tax, 1861–1913. New York: Oxford University Press, 1993. Steinmo, Sven. Taxation and Democracy: Swedish, British, and American Approaches to Financing the Modern State. New Haven: Yale University Press, 1993. 269

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270

Index A Abraham, Spencer: as Energy Secretary, 5; defeated in Senate race in 2000, 118; sponsors legislation to repeal estate tax, 140 Accelerated Cost Recovery System (ACRS), 61 ACM Partnership v. Commissioner, 161 Act of July 1, 1862: imposing a national gift and inheritance tax, 141 Act of July 14, 1870: repealing Civil War inheritance and succession taxes, 142 Agnew, Spiro, 58 Aldrich, Nelson: as chairman of Senate Finance Committee, 27 alternative minimum tax (AMT): relief from AMT for middle-income taxpayers, 105; history; 122; applying to middle class taxpayers, 122; relief from AMT under Tax Relief Extension Act of 1999, 122; relief provided in May 2001 Republican tax plan, 129; need for “fix” to exempt middleclass taxpayers, 172; who pays AMT, 250n.27 American Bar Association Section of Taxation: supports increased penalties for corporate tax shelters, 164 American Dream Restoration Act of 1995, 80 American Institute of Certified Public Accountants: supports increased penalties for corporate tax shelters, 164 Anderson, John: presidential candidate in 1980, 59 annual exemption from gift and estate tax, 152 Archer, Bill: as chairman of House Ways and Means Committee, 77, 80; leading campaign for Contract tax provisions, 80; supports capital gains cut, 88; promises to repeal holding period for capital gains, 95; blocks technical correction to estate tax, 96; as architect of 1999 GOP tax bill, 100; proposal to fix marriage penalty tax, 108; re-

tires after 2000, 117; leads effort to repeal estate tax, 140; blocks legislation to curb corporate tax shelters, 167; leads initiative to repeal of 18-month holding period for capital gains, 195; Archer Medical Spending Account, 244n.43 Armey, Richard: voted new majority leader for 194th Congress, 77; leads campaign for Contract tax provisions, 80; proponent of flat tax, 82; continues as House majority leader after 2000 elections, 117; presents plan for tax cuts greater than those of Bush administration, 125; blocks legislation to curb corporate tax shelters, 167

B Baird, Zoe, 193 Balanced Budget Act of 1997, 93, 193 Balanced Budget and Emergency Deficit Control Act of 1985: enactment, 186; see also Gramm-Rudman-Hollings Bankman, Joseph: estimates of costs of corporate tax shelters to U.S. government, 167 Baucus, Max: conservative Southern Democrat, 128; proposes compromise tax plan in May 2001, 129; member of Conference Committee for 2001 tax act, 130; proposes stimulus package in 2001, 134 Bauer, Gary: as GOP presidential candidate in 2000, 102 Bensten, Lloyd: initiates revenue neutral rule in Finance Committee, 188 Blue Dog coalition: conservative Southern Democrats, 128; propose moderate stimulus package in 2001, 134; 251n.38 BOSS tax shelter, 160–61, 166 Bradley, Bill: opposition to corporate tax shelters in 2000 election, 166

271

Index Breaux, John: conservative Southern Democrat, 128; member of Conference Committee for 2001 tax act, 130; introduces proposal to raise exemption for estate tax, 139 Brown, Pat: governor of California, 58 Brushaber v. Union Pacific Railroad Co., 31 Bryan, William Jennings, 25, 27 Budget Enforcement Act of 1990: adopts revenue neutrality as principle of budgeting, 187; imposes pay-as-you-go (PAYGO) on Congress in budgeting, 188; adjustable spending caps, 263n.51 budget resolution (compromise) for 2002 budget, 128 budget surpluses: in late 1990s, 169; difficulty of budgeting in age of surpluses, 172; give misleading statement of overall financial position of federal government, 175; include Social Security surpluses, 176 Burns, James McGregor: theory of four-party system, 241n.7 Bush, George H. W.: tax policy, 10; defeat in 1980 primaries, 59; election to presidency in 1988; budget negotiations with congressional Democrats in 1990, 68; veto of Democratic tax bill in 1992, 70; battles Democrats over the budget and tax policy, 200 Bush, George W.: as compassionate conservative, 5; presidential election in 2000, 8, 13, 200; proposes tax plan, 102; victory in electoral college in 2000 election, 117; proposal to cut taxes $1.3 trillion, 119; address to Congress in February 2001 proposing $1.6 trillion tax cut, 121; formally presents tax reduction plan to Congress, 123; details of Bush tax plan, 123–24; accepts compromise for $1.35 trillion tax cut, 127; pushes for stimulus package in 2001, 135; pledges to repeal federal gift and estate tax, 138; plan to partially privatize Social Security, 182; inability to increase military spending in 2002 budget, 202 Byrd, Robert: proposes homeland security bill in November 2001, 135; author of Byrd rule in Senate, 188 Byrd rule: described, 131, 188–89, 263n.55; role in passage of 2001 tax act, 131; impact on budgeting, 189

C Canada: repeals wealth transfer tax, 156 Carper, Tom: defeats Bill Roth in Delaware Senate race in 2000, 118 carry-over basis alternative, 154 Carter, Jimmy: calls for tax reform, 56; reelection bid in 1980, 59; lack of popularity in 1980, 59 CATO Institute, 184 Chafee, Lincoln: supports moderate tax bill in 2001, 127; votes against 2001 tax act, 131 Chase, Salmon: as secretary of Treasury, 21 Cheney, Dick: tax proposal, 14; as vice president voting in Senate, 13, 117 Christian Coalition: role in 1994 congressional elections, 80 Citizens for Tax Justice, 101 Civil Rights Act of 1964, 49 Civil War: revenue crisis, 21; Republican party domination, 23; history of Civil War income tax, 230n.8 Cleveland, Grover: presidential election of 1884, 25; signed income tax bill of 1894, 26; election of 1888, 230n.17 Clinton, Bill: as Arkansas governor, 10; presidential campaign in 1992, 10; presidential election of 1992, 73; tax policy 73; State of the Union address in 1993, 73; veto of Republican tax bill in 1995, 81; reaction to resurgent Republican party in 1995, 83; negotiations with Republicans in 1995, 85; government shutdown in 1995, 85–86; Line Item Veto Act of 1996 signed into law, 87; reelection in 1996, 88; State of the Union address in 1999, 98; plan to dedicate surplus to Social Security, 98; veto of Taxpayer Refund and Relief Act of 1999, 102– 103; signs into law the Tax Relief Extension Act of 1999, 105; veto of Marriage Tax Penalty Relief Reconciliation Act of 2000, 109; veto of Death Tax Elimination Act of 2002, 137; takes action against corporate tax shelters, 166; proposes “Universal Savings Accounts” (U.S.A. Accounts), 184; proposals for revenue-raisers for fiscal year 2000 budget, 196 Clinton, Hillary Rodham: as First Lady, 76; elected Senator from New York, 118 Cohen, William, 81 company-owned life insurance (COLI): deduction limited, 87–88

272

Index Compaq Computer Corp. v. Commissioner, 162 Congressional Budget and Impoundment Control Act of 1974, 187–88 Congressional Budget Office (CBO): budget estimates in 1995, 85; new prediction of budget surpluses, 98, 140, 169; predictions of surpluses in 1999, 99; January 2001 report on budget and economy, 120; revised budget estimates in August 2001, 132; revised budget estimates after September 11 terrorist attacks, 132; prediction of surplus for fiscal year 1999, 170; assumptions in budget forecasts, 171–72; prediction of $5.6 trillion surplus over ten years, 173; assumptions regarding economic conditions, 258n.4; role of CBO economic forecasters, 258n.8 congressional elections of 1934, 39 congressional elections of 1946, 45 congressional elections of 1954, 48 congressional elections of 1958, 48 congressional elections of 1966, 53 congressional elections of 1994, 75–77 Conservative Action Team, 139 consolidated budget, 99 Contract with America: Republican platform in 1994, 10; proposed by Newt Gingrich, 76; support from GOP freshman class of 1995, 79; tax provisions in Contract, 80; lukewarm support in Senate, 81; as blueprint for refinancing America, 82 Coolidge, Calvin, 35 corporate income tax: increase in refunds, 168 corporate tax shelters: first proposal of Rep. Doggett to regulate, 115; role of Big Five accounting firms and Wall Street investment bankers in promoting, 159–60; Enron’s use of shelters; 160; use of tax havens in creating corporate tax shelters, 161; role of Merrill Lynch in promoting corporate tax shelters, 161; new disclosure requirements for shelter promoters, 165; IRS proposal for voluntary disclosure, 164; estimates of cost to Treasury, 167 Cox, Christopher: leads Republican efforts to repeal estate tax, 139 Cox, James, 31 Crane, Phil: defeated in bid for chair of House Ways and Means Committee, 117 critical election in 1932, 41, 233n.12 Crummey powers, 195

Current Tax Payment Act of 1943, 43, 233n.19

D Daniels, Mitchell: as director of Office of Management and Budget, 133; favors temporary stimulus bill after September 11 terrorist attacks, 133 Darman, Richard: as director of Office of Management and Budget, 69 Daschle, Thomas: as Senate minority leader, 96; presents Democratic alternative to Bush tax plan, 125; becomes Senate majority leader, 131; proposes Democratic stimulus package in December 2001, 136; introduces proposal to raise exemption to estate tax, 139 death as “realization” event, 155 Death Tax Elimination Act of 2002, 137, 138, 186 Deficit Reduction Act of 1984 (DEFRA), 65; amendments to estate tax, 146 deficit spending: when needed, 263n.60 Delay, Thomas: as new GOP majority whip in 104th Congress, 77–78; presents plan for tax cuts greater than those of Bush administration, 125 Democratic party: platform in 1932, 37; oneparty system in South, 41; party coalition during New Deal, 41; Southern conservatives abandon the party, 57, 76; “Boll Weevil” faction, 60; negotiations with Bush administration in 1990, 69; tax policy, 73; control of Senate after 2000 elections, 117; Democratic plans to spend surplus funds on Medicare and Social Security, 174 Dewey, Thomas: as Republican presidential candidate in 1948 direct taxation: under the Constitution of 1787, 229n.3 Doggett, Lloyd: introduces bill to regulate section 527 tax-exempt entities, 114; first effort to regulate corporate tax shelters, 115; introduces Abusive Tax Shelter ShutDown Act, 164; at hearings into corporate tax shelters, 165 Dole, Robert: as candidate for vice president in 1976, 58; as fiscal conservative in Senate, 64; as Senate majority leader and chairman of Finance Committee, 75; opposition to Trent

273

Index Dole, Robert (continued) Lott as majority leader, 78; proposes 15 percent tax cut in 1996 presidential race, 88 Domenici, Pete: as chairman of Senate Budget Committee, 84; on Republican efforts to repeal PAYGO rule, 189 Dove, Robert: Senate parliamentarian, 108, 248n.3 Dreier, David: as House Rules Committee chair, 72 Dukakis, Michael, 68 Dunn, Jennifer: leads House efforts to repeal estate tax, 139, 140

E Earned Income Tax Credit (EITC), 110 Economic Growth and Tax Relief Act of 2001: approved by House in March 2001, 124 Economic Growth and Tax Relief Reconciliation Act of 2001: enactment, 113; details of legislation, 130–31; sunset provisions, 130; effect on budget estimates, 132; phases out estate tax, 137, 140; repeals special $700,000 exemption under estate tax, 139; impact on estate tax, 158; impact on CBO budget forecasts, 174 Economic Recovery Tax Act of 1981 (ERTA): enactment, 61; bidding war for special interest provisions, 60, 237n.11; amendments to gift and estate tax, 145; tax rate reduction, 237n.9; how affects various business interests, 237n.13 education tax credits, 90 Eisenhower, Dwight: as Republican presidential candidate in 1952, 47 empowerment zones: Republican provision for new zones in 2000, 116; four different types, 249n.19 Energy Department: during Bush administration, 5 Enron Corp.: use of corporate tax shelters to reduce income tax, 160 entitlement programs: Social Security, Medicare, Medicaid, food stamps, 177 excise tax on luxury goods, 197

federal excise tax on petroleum products: Republican initiative to reduce, 114 federal gift and estate tax: phaseout under May 2001 Republican tax bill, 129, 252n.1; minor revenue raised, 150; maximum tax rate of 55 percent, 150; possible negative impact on revenue collection, 150–51, 254n.33; Joint Committee on Taxation’s estimate of cost of repealing estate tax, 152; lifetime unified credit, 152; planning devices, 153; impact of repeal on charitable giving, 157, 256n.46; impact on farmers, 253n.4 federal gift tax of 1862, 22 federal income tax of 1861, 22 federal income tax of 1862, 22 federal income tax of 1864, 23 federal income tax of 1894: taxation of gifts and bequests, 142 federal income tax of 1913, 29 federal income tax of 1984, 26 federal income tax: as source of revenue of federal government, 2, 8, 54, 150, 169; nonpartisan use of income tax, 2; as tool of national economic policy, 2; overtly political use, 2; distribution of income tax, 7; tax increases in 1987 and 1988; raises over $1 trillion for first time, 169 federal inheritance tax of 1862, 22 Feldstein, Martin: proposal on refinancing Social Security, 183 Financial Securitization Investment Trust (FASIT), 88; 244n.37 fiscal year 2002: budget debate in Congress, 126; Bush budget, 127 flat tax: Steve Forbes as proponent in presidential race, 82; original proposal, 242n.23 Foley, Thomas: as Speaker of the House during 103rd Congress, 77 Forbes, Steve: as proponent of flat tax, 82; quick exit from 2000 election, 113 Ford, Gerald, 58, 79 foreign sales corporation, 116 Friedman, Milton: impact of inflation on tax rates, 54: opposition to investment of Social Security Trust Fund assets in private stocks, 262n.38

F federal budget: as statement of cash flow for coming fiscal year, 175

G Garrett, Elizabeth: describing effects of PAYGO rule on budgeting, 188

274

Index Generally Accepted Accounting Principles (GAAP), 175 generation skipping tax (GST), 137, 145, 146 Gephardt, Richard: as House minority leader, 96; presents Democratic alternative to Bush tax plan, 125 Gingrich, Newt: as leader of antitax faction in House, 65; founder of Conservative Opportunity Society in 1982, 75; leader of GOPAC, 76; proponent of Contract with America, 76; voted Speaker of the House, 77; control over GOP freshman class of 1995, 80; purported snub by Clinton in 1995, 86; investigated by House Ethics Committee, 97; challenge to leadership, 97; unseated as Speaker, 98 Glitz v. Commissioner, 134 Goldwater, Barry: first elected to Senate, 47; as embodiment of conservative Republicanism, 49; beginning of presidential campaign, 50; questions Social Security, 52, 182; capture of 1964 Republican nomination, 50 GOP freshman class of 1995, 79–80 Gore, Al: as vice president, 74; tax credits proposed in 2000 presidential race, 91; in debate over marriage tax penalty, 110 Graetz, Michael: defense of progressivity of estate tax, 147 Gramm-Rudman-Hollings: original legislation to eliminate deficit, 186; how led to manipulation of budget rules, 186 Grand Old Party: origin of name, 1, 227n.1 Grassley, Charles: as chairman of Senate Finance Committee, 118; proposes compromise tax plan in May 2001, 129; as member of Conference Committee for 2001 tax act, 130; proposes stimulus package in 2001, 134; sponsors legislation to raise exemptions to estate tax, 140 Great Depression: tax rates during 1930s, 144 Greenback party, 25 Greenspan, Alan: as head of president’s Council of Economic Advisers, 63; as chairman of Federal Reserve Board, 120; supports tax cut in January 2001, 121; opposes tax cuts after September 11 terrorist attacks, 133; CBO assumptions regarding Federal Reserve Board’s interest rate policy, 171; opposition to Republican plan to invest So-

cial Security Trust Fund assets in stock market, 260n.24

H Hall, Robert E.: on use of taxes to manipulate business cycle, 126 Halleck, Charles: as majority leader, 45, 47, 79 Hanna, Mark: election of 1896, 26 Harding, Warren G., 31, 32 Hastert, Dennis: as new Speaker of the House, 98; building moderate support for 1999 GOP tax bill, 100; as moderate in 2000, 107; opposes Clinton veto of 2000 Republican tax bill, 109 Hatch, Orin, 96, 102 Health Insurance Portability and Accounting Act of 1996, 87 Heritage Foundation, 184 Hoover, Herbert: prior political experience, 35, 36; defeated by Roosevelt, 35–36 horizontal equity, 112 House stimulus package 2001, 133 House Ways and Means Committee; and Thaddeus Stevens, 21; consideration of new income tax in 1864, 23; during the 1960s and 1970s, 53; consideration of Clinton tax plan, 74; tax reduction plan in March 2002, 124; conducts hearings in 1999 on corporate tax shelters, 166 Hughes, Charles Evans, 30 Hulshof, Kenny; leads House effort to repeal estate tax, 139 Humphrey, Hubert: as Democratic presidential candidate in 1968, 53

I income shifting, 151 incrementalism, 55 Internal Revenue Service Restructuring and Reform Act of 1998: enactment, 94, 194; ten deadly sins, 245n.58 Internal Revenue Service: GOP efforts to restructure, 93; Senate Finance Committee investigations in 1997 into alleged abuses, 93; Republican attacks on IRS, 12; IRS public notice on kidnapped children, 115; budget for 2002, 153; decline in audit rates, 245n.59; decline in number of employees, 256n.12

275

Index IRS Office of Tax Shelter Analysis, 164 IRS Oversight Board, 94 –95

Knudsen, Harold: as chairman of House Ways and Means Committee, 46 Kyl, John: introduced proposals in Senate to repeal estate tax, 139

J Jeffords, Jim: defection from Republican party, 13; supports tax plan more moderate than Republican bill in 2001, 127; rumors of defection from GOP, 129; votes for May 2001 Republican tax bill, 129; votes for 2001 tax act, 131; supports Senate Democratic stimulus package in November 2001, 135 Job Creation and Worker Assistance Act of 2002: enactment, 136 John Birch Society, 53 Johnson, Lyndon: as vice president, 49; elected president, 49; Great Society programs, 51 Joint Committee on Taxation: estimates of retroactive tax relief under 2001 tax act, 130; estimates of revenue from estate tax, 151; estimates of cost of repealing estate tax, 152; Lindy Paull as chief of staff, 162; estimates of provision on employerprovided meals, 194; estimates of revenue losers in 1998 tax act, 195; 2001 study on tax simplification, 250n.26 joint tax return: origin in 1948, 111

K Kasich, John: as chairman of House Budget Committee, 84; Republican efforts to repeal PAYGO rule, 189 Kemp, Jack: co-sponsor of “Kemp-Roth I” tax proposal, 60; as head of Empower America, 63; losing bid for presidential nomination, 239n.25 Kennedy, Edward: challenges Jimmy Carter in 1976, 59; proposes stimulus package in 2001, 134 Kennedy, John F.: elected president in 1960, 49; call for tax reform, 55; proposal to repeal basis step-up and tax gains at death, 155 Keyes, Alan: as GOP presidential candidate in 2000, 102 Kies, Ken: opposition to legislation against corporate tax shelters, 165–66 King, Ronald: on entitlement spending, 178 Kitchin, Claude, 29

L La Follette Jr., Robert: income tax proposals, 37 La Follette, Robert, 28 Landon, Alf: as Republican presidential candidate in 1936, 40; criticism of Social Security, 233n.12 Largent, Steve, 97 LILO (“lease in, lease out”) transaction, 163 Lincoln, Abraham: 1860 presidential election, 20 Lindsay, John, 51 Line Item Veto Act of 1996, 87; 244n.36 Livingston, Bob, 97 Lodge, Henry Cabot, 28, 30 Long, Huey: “Share Our Wealth” campaign, 37 Long, Russell, 108 Lott, Trent: elected Senate majority leader, 78; proposes tax cuts to Clinton, 89; returned as Senate majority leader after 2000 elections, 117; sponsors legislation to raise exemptions to estate tax, 140 Lowi, Theodore J., 232n.5, 232n.6 Lugar, Richard: support for national sales tax, 82; sponsors legislation to repeal estate tax, 140 Luntz, Frank, 137

M Madisonian system of checks and balances, 200 Manufacturers’ Club of Philadelphia, 32 marriage penalty tax, 108–14, 249n.11 Marriage Tax Penalty Relief Act of 2000, 108 Marriage Tax Penalty Relief Reconciliation Act of 2000, 109 Martin, Joseph: as Speaker of the House, 45 McAdoo, William, 29 McCaffery, Edward: as critic of estate tax, 148– 49 McCain, John: Republican presidential candidate in 2000, 104; critical of 1999 GOP tax bill, 104; support for bill to regulate section 527 tax-exempt entities, 114; votes against 2001 tax act, 131

276

Index McIntyre, Robert: director of Citizens for Tax Justice, 101 McKinley, William: election of 1896, 26 McMillin, Benton, 25 medical spending accounts: proposed by House, 87 Medicare: estimates of insolvency, 176 Mellon, Andrew: as secretary of Treasury, 32; tax reduction plan of 1923, 33; philosophy on taxation, 232n.35 Merrill Lynch: role in promoting corporate tax shelters, 161, 162; settlement with IRS, 256n.6 Michel, Robert, 77, 79 Miller, William, 50 mini-max strategy, 235n.33 Mondale, Walter, 65 Moral Majority, 57 Morrill, Justin: proposal for first federal income tax, 22–23; as member of House Ways and Means Committee, 22; opposition to income tax in 1984 Morse, Wayne, 234n.26 Moynihan, Daniel: ranking Democrat on Senate Finance Committee, 115; proposal to regulate corporate tax shelters, 115; retires from Senate, 118; co-chair of commission on Social Security, 183

tions of surpluses, 99; estimates of increased entitlement spending, 177 Office of Tax Analysis, 110 Old Guard: as conservative wing of Republican party, 19; and income tax, 21; opposition to Progressive regulatory agencies, 28, 231n.26; opposition to income tax of 1913, 28; strength in Northeast and New England, 32; support for national sales tax, 33; hatred for Roosevelt tax policy, 38; control of Republican party during New Deal period, 39; commitment to limited government and states’ rights, 45; defeat in congressional elections in 1958, 48; victory in 1980, 59; origin of term, 229n.1; strategy to wait out New Deal, 233n.9 Omnibus Budget Reconciliation Act of 1990: enactment, 69; phaseout of personal exemptions and itemized deductions, 240n.37; impact of phaseouts on marginal rates, 240n.38; see also phaseouts of exemptions on-budget surpluses, 99, 170 O’Neill, Paul: as secretary of Treasury in 2001, 134

N Net operating loss (NOL), 99, 194, 246n.70 New Deal: tax legislation, 38; administrative agencies created, 42 New Right: social conservatives, 5; in 107th Congress, 13; supporting Ronald Reagan in 1980, 57; critical of Republican bill to eliminate marriage tax penalty, 249n.12 Nixon, Richard: as a Keynesian, 4 –5; first elected to Congress, 45; call for tax reform, 56; elected president in 1968 and 1972, 58 NLRB v. Jones & Laughlin Steel Corp., 234n.21

O off-budget surpluses, 99, 169 Office of Faith-Based and Community Initiatives, 5 Office of Management and Budget (OMB): budget estimates in 1995, 85; 1999 predic-

P Panic of 1857, 21 Parsons, Dick: co-chair of commission on Social Security, 183 Passive Activity Loss (PAL) rules, 159 Paull, Lindy: as chief of staff of Joint Committee on Taxation, 162 PAYGO rule: adopted as budget rule in 1990, 188; as mechanism to create zero-sum environment for budgeting, 188; Republican efforts to repeal, 189; benefits of PAYGO rule, 189–90; problems of PAYGO rule; 190–91; imposes revenue neutrality on budgeting, 191–92; requires revenue offsets, 192–97; benefits outweigh costs, 198; OMB’s baseline for determining sequestration, 262n.44 Perot, Ross: Reform party candidate in 1992, 73 personal residence: exemption for gain, 91 Personal Responsibility and Work Opportunity Reconciliation Act of 1996, 87 phaseouts of exemptions: enacted under Omnibus Budget Reconciliation Act of 1990, 69, 240n.37; impact of phaseouts on margi-

277

Index phaseouts of exemptions (continued) nal rates, 240n.38; Democratic opposition to repeal in 2001, 251n.44 pluralism, 55 Poe v. Seaborn, 111 political parties: in the United States, 3; 6; post–Civil War party system, 25; critical election in 1932, 41, 233n.12; battled over tax policy in the 1990s, 200 Pollock v. Farmer’s Loan & Trust Co., 26, 27; 231n.21 Populist party: platforms for progressive income tax, 25; pressure for income tax of 1894, 142 presidential election of 1936, 40, 41 presidential election of 1952, 47 presidential election of 1964, 51 presidential election of 1980, 58–59 presidential election of 2000, 117–19 PricewaterhouseCoopers: role in promoting corporate tax shelters, 160 Progressive era state-building, 231n.25

R Ramstad, Jim: proposal for deduction for kidnapped child, 115 Rangel, Charles: presents Democratic alternative to Bush tax plan, 125; introduced proposal to raise exemption to estate tax, 139; co-sponsor of Abusive Tax Shelter ShutDown Act, 164 Rawls, John: support for wealth transfer tax, 148– 49 Rayburn, Sam, 236n.43 Reagan, Ronald: antitax electoral campaign, 9; nomination of Barry Goldwater at 1964 Republican convention, 50, 57; running for governor of California, 58; critical of Social Security program, 58, 182; efforts to reduce Big Government, 199; decision to run for president, 237n.3; call for tax reform, 239n.26 Reed, Daniel, 47 Reed, David, 39 Reed, Ralph, 80 reforms of estate tax, 156 Regan, Donald: as secretary of Treasury, 66 Republican National Convention of 2000, 109 Republican party: tax policy as prominent issue, 1; consistency of doctrine, 3; antitax

sentiment, 3; commitment to limited government, 3; commitment to federalism, 4; commitment to anticommunism, 4, 20; electoral strategy, 7; “Old Guard,” 19; origin, 21; domination of post–Civil War period, 25; electoral strategies during New Deal, 40; liberal wing, 51, 57; primaries in 1980 presidential election, 59; proinvestment wing of party, 63; fiscal conservatives in party, 64; antitax wing of GOP in 1998, 92; antitax wing after 2000 election, 117; tax bill in 1999, 100; strategy for tax proposals in 2000, 107; control of 107th Congress, 113; Republican efforts to repeal PAYGO rule, 189; “new Republican majority,” 234n.31; realignment in the South, 241n.10; see also Right Wing, Old Guard Responsible Wealth, 228n.11 Revenue Act of 1916: income tax, 29; new estate tax, 143 Revenue Act of 1917: increased income tax and estate tax rates, 144; politics behind, 232n.30 Revenue Act of 1936, 40, 41 Revenue Act of 1938, 38 Revenue Act of 1939, 43 Revenue Act of 1949, 49 Revenue Act of 1954, 47 Revenue Reconciliation Act of 1993, 74 Right Wing: social conservatives, 5; comeback in 1994, 10; blocking Eisenhower, 47; support for Ronald Reagan in 1980 presidential race, 58 Riker, William, 235n.33 Rockefeller, Nelson, 48, 50 Romney, George, 50 Roosevelt, Franklin: as Democratic presidential candidate in 1932, 36; major tax proposals in 1935, 38; plan to “pack” Supreme Court, 43; death, 45 Roosevelt, Theodore: as successful Republican president, 10; election of 1912; proposal for new progressive wealth transfer tax Rostenkowski, Dan: warning of dangers of radical reform proposals, 113; budgeting rule for Finance Committee, 188 Roth IRA: liberalization of rules for conversion, 97; as revenue-raiser for 1998 tax act, 195 Roth, William: co-sponsor of “Kemp-Roth I” tax proposal, 60; as chairman of Senate Fi-

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Index nance Committee, 78; sponsor of increased IRA coverage, 81, 89; sponsor of “Roth IRA,” 90; mark-up of 1999 Senate tax bill, 101; secures enactment of new tax credit for renewable energy sources (poultry waste), 105; denounces marriage penalty tax, 108; support for legislation to regulate corporate tax shelters, 115; defeated in 2000 election, 118; on corporate tax shelters, 167; Republican efforts to repeal PAYGO rule, 189 Rubin, Robert, 91

S Saba Partnership v. Commissioner, 162 Schechter Poultry v. United States, 234n.20 Schedule D, 91 Schmidt Baking Co. v. Commissioner, 195 Scranton, William, 50 section 179 expensing, 87 section 527 tax-exempt entities: legislation to regulate, 114; 249n.14 Seidman, Laurence: plan to enhance rate of return on Social Security Trust Fund assets through private investment, 185 Senate Centrists: propose moderate stimulus package in 2001, 134 Senate Finance Committee: Senator John Sherman on committee, 24; during the 1960s and 1970s, 53; committee hearing on IRS “abuses” in 1997, 93; passes stimulus package in November 2001, 135 September 11 terrorist attacks: effect on economy, 132 Shelby, Richard: switches to Republican party, 76; sponsors legislation to repeal estate tax, 140 Sherman, John: efforts to retain income tax of 1864, 24; opposition to income tax in 1894; support for Civil War income tax, 231n.19 Simons, Henry, 37 Sixteenth Amendment: Republican proposals to repeal, 11; ratification, 27–28; 229n.15, 231n.24 Small Business Job Protection Act of 1996, 87 Smith, Al: as Democratic presidential candidate 1928, 35, 36, 232n.1 Smoot, Reed, 33 Snowe, Olympia: supports automatic “trigger” for tax cuts, 119

soak up tax credit, 144 soak-the-rich tax policy: during Roosevelt administration, 41, 43; during Clinton administration, 73, 74 Social Security Trust Fund: use of surplus funds by Congress, 100; $150 billion surplus for fiscal year 200, 170; estimates of insolvency, 176, 259n.11; current surpluses and reserve, 179; current surpluses masking overall insolvency of system over 75 years, 181–82; plans to invest Trust Fund assets in private investments, 184, 260n.21, 260.n.22; Milton Friedman’s opposition to investment in private stocks, 262n.38 Social Security: payroll tax, 9; unfounded liability over 75 years, 174 –75, 202, 259n.11; actuarial assumptions over 75 years, 175; as largest entitlement program, 177; intergenerational transfer, 178, 259n.19; changing demographics, 178; “pay-as-you-go” (PAYGO) system of financing, 179; enhancing the financial position, 179; political attempts by Clinton and Democrats to enhance solvency, 180–82; political attempts by Republicans to privatize, 182; as “Third Rail” of American politics, 16, 182; George W. Bush’s plan to partially privatize, 182; plans to increase rate of return on investments, 184; Roosevelt’s plan for distributing benefits of program, 259n.15; progressivity of benefits, 259n.20; academic supporters of privatization, 261n.30 Spanish-American War, 142 Spector, Arlen: flat tax supporter, 82; supports automatic “trigger” for tax cuts, 119 Stamp Act of July 6, 1797: first federal inheritance tax, 141 Stein, Herbert, 181 step-up in basis: explained, 147– 48; cost to Treasury, 154 Stevens, Thaddeus: as chairman of House Ways and Means Committee, 21; proposal for a national land tax, 21; consideration of income tax of 1864, 23 stock market crash 1929, 35 Stockman, David: as director of Office of Management and Budget, 60 Sullivan, Martin: estimates of costs of corporate tax shelters to Treasury, 167 Summers, Lawrence: as secretary of Treasury, 101, 164

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Index supply-side economics: supporters in first Reagan administration, 62, 238n.14; declining influence in Reagan administration, 64; revenue offset from behavioral response, 238n.16 Supreme Court: reaction to New Deal, 44; Roosevelt’s attempt to “pack” Court, 43– 44

T Taft, Robert: head of conservative faction in Republican party, 45; death in 1953, 47 Taft, William Howard, 27, 28, 45, 231n.22, 231n.23 Talent, James, 86 targeted tax relief: proposals in 106th Congress, 116 tariff: during Civil War, 21; as revenue source after Civil War, 24; produces surpluses in 1880s and 1890s, 191 tax brackets: indexing in 1981, 236n.44 Tax Code Termination Act of 1998, 92 tax cuts: popularity among voters, 227n.2, 247n.75 tax deadlock, 71, 202 Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), 64 Tax Expenditure Budget: as source of revenue raisers required under PAYGO, 193 tax havens: use in corporate tax shelters, 161 Tax Reform Act of 1986 (TRA): enactment, 66; tax reduction provision, 67; amendments to gift and estate tax, 146; revenue neutrality as principle, 187; coalition of supply-siders and liberal Democrats, 187; politics behind TRA, 239n.28; overall progressivity of TRA, 240n. 30 Tax Relief Extension Act of 1999: enactment, 105; providing three years of relief from AMT, 122 tax simplification: Joint Committee on Taxation 2001 study, 250n.26 Taxpayer Refund and Relief Act of 1999, 102, 138 Taxpayer Relief Act of 1997, 90–91, 93, 138, 145, 193 ten deadly sins: 245n.58 Thomas, William: as chairman of House Ways and Means Committee, 117; lobbies for

House tax plan in spring 2001, 125; member of Conference Committee for 2001 tax act, 130 Thurmond, Strom: as Dixiecrat candidate for president in 1946, 46; as 98-year-old Republican Senator, 119; sponsors legislation to repeal estate tax, 140 Torricelli, Robert: support for Republican tax bill in May 2001, 129 Treasury Department: issues “White Paper” on corporate tax shelters, 115; search for revenue-raisers, 197 Truman, Harry: as Vice President, 45

U U.S. Tax Court: litigation over tax shelters in the 1980s, 159 United States v. Darby, 234n.21 Universal Savings Accounts (U.S.A. Accounts): proposed by Clinton, 99, 184

W Wallace, Henry: as Vice President, 46 Wanamaker, John, 32 War Revenue Act of 1898: imposing new wealth transfer tax during SpanishAmerican War, 142 War Revenue Act of 1917, 30 Watts, J. C., 86 wealth distribution in United States, 228n.10 wealth transfer tax: liberal defense of, 146– 47 Weinberger, Mark: as Assistant Secretary of Treasury for Tax Policy, 166–67 Wherry, Kenneth, 46 White House Budget Blueprint: released in February 2001, 123 Wickard v. Filburn, 234n.21 Wildavsky, Aaron, 72 Wilson, Woodrow: elected president 1912, reelection in 1916, 30 Winn-Dixie Stores, Inc. v. Commissioner, 162 World Trade Organization (WTO): requires repeal of foreign sales corporation provision in U.S. income tax, 116 World War I: impact on U.S. revenue, 143– 44 World War II: impact on U.S. revenue and tax rates, 144

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