A Fine Mess

by T. R. Reid

  The focus on purity has been so successful that New Zealand ranks among the richest countries in the world. It was one of the earliest members of the OECD. When it joined that international group in 1973, New Zealand had a tax code that looked like the tax structure in other rich countries. It relied primarily for revenue on a personal income tax, and the tax was riddled with exemptions, credits, and giveaways for particular groups and companies. In short, it was the opposite of BBLR. All those preferences made for a fairly narrow tax base, which meant that tax rates had to be high to raise the required revenue. By the early 1980s, the country’s top marginal income tax rate was 66%. “We had an income tax that was like a swiss cheese, it had so many exemptions,” a veteran Kiwi bureaucrat, Graham Scott, told me. “And with all those holes in it, the rates had to be kept high to bring in the money we needed.”

  Graham Scott told me that “in the ’70s a wine expert—an enologist, he’s called—came to visit from the University of California. Well, this bloke noticed that our Marlborough region [basically, the northeast corner of the South Island] had a geography and a climate that looked like Napa Valley. Well, a few entrepreneurs drove out the sheep and started planting the grapes that you grow in California. And this has turned into a huge export industry. The sauvignon blanc from Marlborough is world famous now; we export more sauvignon blanc to the United States than France does! But at first, nobody had ever heard of a Marlborough wine. So we gave the winemakers all sorts of tax benefits in the beginning. Hell, that’s what we always did; in those days, we were giving every industry tax breaks, left and right. That’s one of the reasons we had all those holes in the income tax.”

  In the 1980s, Graham Scott became the policy chief in New Zealand’s Finance Ministry, which meant that fixing that swiss-cheese tax code was his job. (He did the job so well that the queen knighted him for his work; he is now Sir Graham Scott, although he seemed embarrassed when I called him that.) When Scott took over the policy shop, the Labour Party—roughly like the U.S. Democratic Party—had just won a national election. The Labour finance minister, Roger Douglas, Scott recalls, wanted to “clean up” the tax code.

  “We said, ‘Roger, what do you mean, “Clean up”?’ And he said, ‘Let’s cut out all the special business allowances. Let’s cut out all the agriculture subsidies.’ Frankly, the politics of it were favorable, because Labour didn’t have farm support anyway, didn’t have business support. So we could get rid of all the special allowances and rebates and deductions. In those days, we had tax incentives for timber companies; for tourist companies; for insurance companies; hell, you could deduct the premiums for your life insurance policy. If a company built a factory for $10 million, we would let them depreciate the whole $10 million in the first five years, even though the building would last for fifty. Well, we killed all of those write-offs. We didn’t allow individuals to take the two big deductions that your U.S. has, for mortgage interest and contributions to a church.”

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  THIS WAS BASE BROADENING on steroids, but even so, the bureaucrats did not satisfy Douglas, the finance minister. He wanted to cut the top income tax rate in half. But even with virtually all preferences eliminated from the tax code, the government couldn’t get enough revenue with such low rates. To solve that problem, Scott and his fellow bureaucrats proposed a national sales tax—they called it the goods and services tax—and used the same broad-based approach for that levy. Unlike other countries’, New Zealand’s GST applied to virtually any product or service you could buy (including the prostitutes in the legal brothels). With that addition, the income tax rates could be cut in half for every taxpayer in the nation—with no loss of revenue to the government.

  In essence, New Zealand’s government said to its citizens, “If you want to make a contribution to charity, that’s fine. But you don’t get a tax break for it. If you want to take out a mortgage to buy a house, that’s good. But you don’t get a tax deduction for the interest you pay. You want to put a solar array on your roof? Great idea, but don’t expect a tax write-off. If you buy a life insurance policy to protect your family, more power to you. But we’re not going to let you deduct the annual premium.”

  Inevitably, taxpayers and businesses that lost a cherished deduction complained angrily. “But we said to them, if you want to keep that deduction, we’ll have to raise the rates for everybody,” Scott recalls. “And people understood the trade-off; you lose a deduction, but you get a simpler tax code and much lower rates.” From the left, there were complaints that the big cut in income tax rates was a gift to the richest Kiwis. “But we said to them, the tax is still progressive,” Scott says. “The more income you have, the higher your tax rate. But a progressive tax doesn’t necessarily have to soak the rich.” Tax lawyers and accounting firms also complained, Scott told me, “because after all we were putting a lot of them out of business when we took away all the loopholes they used to manipulate.”

  In the end, the sweeping reform was widely accepted—by individuals, businesses, and both major political parties. “It was a success. Even the conservatives eventually had to accept that this was extremely popular,” said Maurice McTigue, who was a member of Parliament at the time from the National Party, the conservative opposition. “A key reason was that we did it big. They changed almost everything at once. And that’s an important lesson: if you’re going to do tax reform, you’d better make it a large reform. That way, for every change a taxpayer doesn’t like, there’s something else in the package that he wants.”

  Despite the predictable efforts of various industry and interest groups to wedge their favorite tax preferences back into the tax code, New Zealand clung fairly tightly to the BBLR principle over the next two decades. Over time, though, some deductions and credits were permitted—including that accelerated depreciation write-off that Graham Scott thought he had killed. All this narrowed the tax base and forced the government to raise income tax rates; the top income tax rate had risen from 30% in 1986 to 39% by 2010. Taxpayers were not happy. And so New Zealand did tax reform again; in 2010, deductions and credits were cut, and that accelerated depreciation scheme was killed (for the second time). Income tax rates could be cut yet again, with no loss of revenue.

  The result is a tax code that imposes the lowest rates on average workers of any developed nation. The comparison with the United States is instructive. An American couple bringing in the median family income—about $55,000 per year—and taking the standard deduction will pay about 15% of their annual earnings in personal income tax, another 6.5% in Social Security tax, another 2.9% for the Medicaid tax, and roughly 5% in state income tax. In addition, an average American family will pay 5% to 10% of income for health insurance. Add it all up, and the median earner in the United States is paying about 35% of earnings for taxes and health care. (A self-employed American would pay even more, because Social Security taxes and health-care premiums are higher for the self-employed.)

  In New Zealand, in contrast, the median wage earner pays about 17.5% in income tax. But that one payment also covers his old-age pension (there’s no separate tax for Social Security), plus free health care for life (there’s no separate tax for health care), plus free education through college graduation (there’s no separate tax for schools). So the average New Zealander’s wages are taxed at less than half the rate of the average American’s. And yet New Zealand provides more government services than the United States—with half the tax rate. That’s the beauty of BBLR.

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  NEW ZEALAND’S EXPERIENCE IS INSTRUCTIVE, but what does it have to do with the United States? It’s an island country, closer to Antarctica than to the equator, with four million people and about as many sheep. It has a unicameral legislature and a government tradition in which elected politicians defer to professional bureaucrats—like Sir Graham Scott—on all the important policy questions. In a country like that, a major change of the national tax code must be easier to achiev
e than in a sprawling, contentious place like the United States, where nearly all public policy issues are heavily politicized and corporate money flows freely through the halls of Congress. With our fractious politics and our sharply polarized electorate, surely the United States could never bring about a tax reform as sweeping and as successful as New Zealand’s swing to BBLR.

  But, in fact, we did.

  In the mid-1980s, the American political landscape was as fractious as it is today. The Republican president had won a substantial electoral college victory, but the country was polarized. The government then was divided, with a conservative president from California battling a liberal House of Representatives led by a Democrat from Massachusetts. With leaders of both parties constantly maneuvering for political gain, Washington was gridlocked on the major issues. There wasn’t much hope for significant progress in any policy area and certainly not on tax reform.

  The election in 1980 of President Ronald Reagan, an unabashed tax hater, launched a flurry of tax laws that pushed rates down, up, down again, and up again with no clear pattern. In Reagan’s first months in office, he successfully pressured Congress to pass the Economic Recovery Tax Act of 1981—known inside the Beltway as ERTA—giving big tax cuts to every individual and corporate taxpayer. (ERTA was so laden with breaks and credits for various industries that it was called, accurately, “a frenzied craze of tax giveaways.”6) The economic rationale for this huge tax reduction was the so-called “supply-side” argument that lower taxes would stimulate business activity and bring in more revenue. Sadly, as we’ve seen, this something-for-nothing theory has never worked in practice. ERTA led to such a big jump in the government’s deficit that Reagan and Congress quickly reversed course, increasing taxes the next year in the Tax Equity and Fiscal Responsibility Act—known as TEFRA. That was followed by tax cuts in 1983, and yet another tax increase in the Tax Reform Act of 1984 a year later.

  By the time Reagan won reelection in 1984, the U.S. tax code was, as the economist Henry Aaron put it, “a swamp of unfairness, complexity, and inefficiency . . . that represents no consistent policy.” Each new exemption or credit spawned many more. Oil drillers had traditionally enjoyed a tax break called a depletion allowance, based on the theory that the amount of oil in the well must be depleting over time. Seeing that, other industries clamored for their own depletion allowances, and Congress responded. By the mid-1980s, the tax code allowed depletion or depreciation allowances that cut taxes for cement companies, Christmas tree farms, apple orchards, gravel pits, railroad cars, rubber importers, cattle growers, and many, many more. There was even a depreciation allowance for human beings; professional sports teams were allowed to write off their players as “depreciable assets” as they slowed down with age.

  Nobody defended this mess, but hardly anybody expected things to get better. When the Treasury Department began testing various reform plans in 1984–85, the respected political scientist John Witte wrote that “there is nothing, absolutely nothing . . . that indicates that any of these schemes have the slightest hope of being enacted in the forms proposed.”7

  And yet there were two men in official Washington who still believed that liberals in Congress and the conservative in the White House could agree on significant tax reform. These two were strange bedfellows indeed. One of them, a conservative Republican, was a Wall Street tycoon; the other, a liberal Democrat, was a basketball star.

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  THE WALL STREETER WAS Donald Regan, who left his post as chairman of the nation’s largest stockbrokerage, Merrill Lynch, to become secretary of the Treasury in Reagan’s cabinet. Despite his position at the top of the financial community, Regan had a populist, anti-establishment streak. Like everybody else, Regan considered the U.S. tax code an unruly beast that badly needed taming. But unlike most of his predecessors, the new cabinet secretary began talking regularly to tax policy experts deep in the Treasury bureaucracy. He encouraged the bureaucrats to think boldly; among much else, he dispatched a pair of economists to New Zealand to study the bold changes the Kiwis were making under the guidance of Sir Graham Scott. By the end of 1984, Regan and his policy team had put together a sweeping tax-reform plan—it became known as Treasury I—that incorporated the basic principle of “broadening the base to lower the rates.” When James Baker replaced Regan as Treasury secretary, he, too, became an advocate for the BBLR approach to tax reform.

  This was a concept that the other key reformer, Bill Bradley, had championed even before Treasury I was issued. An all-American at Princeton and a Rhodes scholar, Bradley came home from Oxford to join the New York Knickerbockers of the National Basketball Association. He became the team’s biggest star, and the best paid as well; he was given the nickname Dollar Bill. Fellow players steered Bradley to the usual army of tax lawyers and accountants, who showed him all the legal tax-avoidance mechanisms available to the richest of taxpayers. Bradley said he found it appalling. He was even more disturbed when the Knicks’ finance chief mentioned that the team could label its star forward a “depreciable asset,” and thus cut its taxes. Bradley later recalled that he really got interested in the U.S. tax code when he learned that “I had been a loophole for the New York Knicks.”

  Bradley was elected to the U.S. Senate in 1978, and he brought to this new position the same determination and diligence that had made him a standout in school and in sports. I was a reporter covering the U.S. Senate on January 15, 1979, when the new Congress convened and the newly elected senators were sworn in, with great hoopla. Right after that formal ceremony, all the members left the Senate floor to attend celebratory parties—all of them, that is, except Senator Bradley. On his first day in the Senate, he spent some three hours at his desk going over the Senate rules with the parliamentarian.

  With a seat on the tax-writing Finance Committee, Bradley immersed himself in the policy and politics of tax reform. He made an important discovery: in taxation, the policy issues and the political considerations neatly overlapped. Lowering the rates was something Republicans wanted. Broadening the base—cutting out special interest preferences—was something Democrats wanted. So combining a broad base with low rates should win support from both parties and thus get a real reform bill through Congress. Bradley used this combination approach in a tax bill he introduced, the Fair Tax Act, which proposed to cut the top marginal rate by half, to 30%.

  “The trade-off between loophole elimination and a lower top rate became obvious,” Bradley wrote later; “the lower the rate, the more loopholes had to be closed to pay for it.”8 Bradley stuck to the mantra of “broad base, low rates” for years, telling anybody who would listen that a significant cut in tax rates would win the votes needed to broaden the base. “The key to reform was to focus on the attractiveness of low rates, not on the pain of limiting deductions.”

  The enticement of low rates also helped land a crucially important supporter for tax reform: Ronald Reagan himself. As a major Hollywood star, Reagan had been a member of the financial 1% in the 1950s, when the top marginal income tax rate was 90%. The sting of the annual tax return, Reagan used to say, was one of the factors that converted him from a liberal labor union leader to a conservative champion of business. He saw himself as a defender of the hard-pressed average taxpayer. On the stump, he loved to tell an old joke: “The taxpayer—that’s the only person who works for the federal government without passing the Civil Service exam.”

  When Regan, Baker, and Bradley approached the president with a promise to cut the top rate to 30% or lower, accordingly, Reagan signed on. In 1984, the popular president announced that far-reaching tax reform was his top domestic issue—a declaration that made it harder for his fellow Republicans in Congress to oppose the reform when the plan came to a final vote in 1986.

  And yet the path to passage, as set forth in the definitive history of the 1986 act, Showdown at Gucci Gulch, was hardly smooth. Every time a reform plan seemed to be getting somewhere in either t
he House or the Senate, corporate lobbyists would swarm in to protect their favored tax break—and each tax break that was approved meant the rates had to go higher. For most of 1984 and 1985, the efforts to overhaul the income tax looked like all the other so-called reform plans of recent years; they made the tax code more complicated and more littered with preferences for the powerful.

  At the end of 1985, the House of Representatives, controlled by liberal Democrats, passed a bill that moved in the direction of reform, although it left the top marginal rate at 38%. But when the Senate Finance Committee, controlled by Republicans, took up the issue, the members seemed far more interested in creating new benefits for various corporate groups than in broadening the base or cutting rates. The vaunted effort to reform our tax code turned into the kind of bill that senators called a “Christmas tree”—there were goodies for everybody.

  By the spring of 1986, the senators were being denounced, in both national and home-state media, for selling out to special interests. Among those taking the heat was the Finance Committee chairman, Robert Packwood of Oregon, a moderate Republican who was up for reelection that year. The Oregon press was bashing him as a corporate stooge, as the man who killed tax reform. They gave him a brutal nickname: Senator Hackwood.