The Tax Reform Act of 1986 Was a Bipartisan Deal Worth Studying

On October 22, 1986, Ronald Reagan sat at a desk on the South Lawn of the White House and signed a bill that almost nobody in Washington had expected to pass. The Tax Reform Act of 1986 cut the top individual income tax rate from 50 percent to 28 percent. It also did something that sounds, in hindsight, almost unbelievable: it raised taxes on capital gains to the same rate as wages, wiped out a large category of tax shelters that wealthy investors had used for decades, and shifted a significant share of the tax burden from individuals to corporations. A conservative Republican president signed it. A liberal Democratic senator from New Jersey had drafted much of its blueprint. A Chicago machine Democrat who chaired the House Ways and Means Committee had forced it through the House. Every one of them had reasons to walk away, and none of them did. It is worth asking why, and why nothing quite like it has happened since.

In short: The 1986 tax law, signed on October 22, 1986, traded much lower rates for a much broader base: fewer deductions, an end to many shelters and capital gains taxed like ordinary income. It was designed to raise the same total revenue while making the code simpler and fairer between taxpayers with similar incomes. Its central bargain unraveled within a few years as rates rose and preferences crept back, but the way it was built still offers lessons for any Congress that wants a bipartisan tax deal.

A code full of holes

To understand 1986, start with the tax code of the early 1980s. The top rate had fallen from 70 percent to 50 percent in Reagan's 1981 tax cut, but the code was riddled with preferences. Wealthy investors could buy into limited partnerships in real estate, oil drilling, cattle feeding, movie production and other ventures designed mainly to generate paper losses. Those losses could be deducted against salaries and other income, wiping out tax bills even for people with very high earnings.

The result was a system that offended almost everyone for different reasons. Conservatives disliked the high nominal rates and the way the code distorted investment. Liberals were angered that some very wealthy people paid little or nothing while wage earners paid the full rate. Economists of every stripe complained that money was being steered into ventures that made sense only for their tax benefits. Corporations with good lobbyists paid little; others paid a lot.

The fairness problem had a precise shape. Two people with the same income could owe very different amounts depending on how cleverly they had arranged their affairs. Economists call that a failure of horizontal equity, and it was the problem the 1986 law was designed to fix.

The senator with a plan

In 1982, Senator Bill Bradley of New Jersey, a former professional basketball player with an unusual appetite for the details of public finance, and Representative Richard Gephardt of Missouri introduced a proposal they called the Fair Tax. The idea was elegant: eliminate most deductions and preferences and use the money to cut rates sharply, with a much simpler bracket structure. Republican Representative Jack Kemp and Senator Bob Kasten had a similar plan from the right.

That convergence was the seed of the deal. Liberals could support base broadening because it would close loopholes used by the wealthy. Conservatives could support it because it would bring rates down. Each side saw the same plan as a victory for its own values.

Reagan, in his 1984 State of the Union address, asked the Treasury to study tax reform, and in November 1984 the Treasury, under Secretary Donald Regan, produced a sweeping proposal that economists still cite as one of the purest reform plans ever drafted. The White House softened it in 1985, adding back some preferences, but kept the core idea.

The machine politician who made it happen

The bill's survival depended on Dan Rostenkowski, the Chicago Democrat who chaired Ways and Means. Rostenkowski was not a policy dreamer. He was a creature of the House, skilled at counting votes and trading favours. He also saw an opportunity: if a Democratic House passed a tax reform bill, Democrats would share credit for fairness and lower rates instead of ceding the issue to Reagan.

After Reagan's televised address on tax reform in May 1985, Rostenkowski gave the Democratic response and invited Americans to write to him, telling viewers to address their letters to "Rosty." Many thousands did. It was a striking piece of political theatre from a man who rarely sought national attention, and it signalled that he intended to own the issue.

The bill nearly died more than once. Lobbyists for every threatened preference lined the halls outside the committee rooms, a scene that gave the era its nickname, Gucci Gulch, and the title of a well-known book about the law by two Wall Street Journal reporters, Jeffrey Birnbaum and Alan Murray. In December 1985, House Republicans initially blocked the bill on the floor; Reagan went to Capitol Hill personally to lobby his own party, and the House passed it.

The two-pint lunch and the Senate surprise

In the Senate, the bill went to the Finance Committee, chaired by Republican Bob Packwood of Oregon, who had no reputation as a reformer. In the spring of 1986 the committee's markup was collapsing under amendments to protect one industry after another. As the story is usually told, Packwood and his top aide, Bill Diefenderfer, went to lunch, drank a couple of pitchers of beer and decided that the only way to save the bill was to go further than anyone had proposed: cut the top rate to the high twenties and wipe out shelters wholesale.

The bold version worked better than the cautious one. Once the rate cut was big enough, senators could tell constituents that they had lost a favourite deduction but gained a much lower rate. The Finance Committee approved the bill unanimously, and the full Senate passed it with only a handful of votes against.

The final law, negotiated in conference over the summer, set two main individual rates, 15 percent and 28 percent, with a phase-out that created a higher effective rate in a middle band of income. It cut the top corporate rate from 46 percent to 34 percent while eliminating corporate preferences, including the investment tax credit, which on net raised corporate taxes. It raised the personal exemption and standard deduction and expanded the Earned Income Tax Credit, taking millions of low-income workers off the income tax rolls. And it created passive-loss rules that stopped most paper losses from shelters being deducted against wages and salaries.

Rifle shots and the price of passage

The law was not as pure as its reputation. To hold the coalition together, its authors wrote dozens of so-called transition rules, special provisions that delayed or softened the new rules for particular projects and companies. Many were written so narrowly that they applied to a single taxpayer, described not by name but by a string of facts, a business incorporated in a certain state on a certain date, for example, that only one company could match. Reporters at the time called them rifle shots.

Those provisions were the price of votes. A member whose district depended on a stadium, a factory or a real estate development could be brought aboard by protecting that project from the new rules for a few years. Critics saw the rifle shots as proof that the reform was compromised from the start. Defenders saw them as the ordinary cost of passing a bill that took away far more than it gave. Both were right. The transition rules were real favours for connected interests, and they were small next to the shelters the law closed.

The story carries a lesson about how reform actually gets done. Fairness for the many was bought, in part, with exceptions for the few. A reformer who refuses every deal of that kind may keep clean hands and pass nothing. A reformer who accepts too many ends up with a bill that looks like the code it replaced.

Who gained at the bottom

The part of the 1986 law that gets the least attention may have done the most good. By raising the personal exemption and the standard deduction, the law lifted millions of low-income workers off the federal income tax rolls entirely. It also expanded the Earned Income Tax Credit, which supplements the wages of low-income working families, and tied it to inflation so that its value would not erode over time.

Reagan himself championed the change, and he spoke well of the earned income credit as a way to fight poverty, a stance that surprises people who know him mainly as the president who cut domestic spending. For conservatives, the credit's appeal was that it rewarded work rather than paying people who did not have jobs. For liberals, it was a way to raise the incomes of the working poor without a fight over the minimum wage.

That shared view built one of the most durable bipartisan programs in American social policy. Later Congresses, under presidents of both parties, expanded the credit again, and it is regularly counted among the federal programs that lift the most working families above the poverty line. In a law remembered for its rate cuts at the top, the biggest proportional gains went to families near the bottom.

Why the bargain held, and why it came apart

The law had a few design features that made the bargain possible. It was revenue neutral by design, so neither side could accuse the other of blowing up the deficit or raising taxes overall. It was distributionally neutral across broad income groups, which kept liberals and conservatives from fighting over who won. And it was comprehensive, which mattered most. Because every interest lost something, no single interest could claim it had been singled out, and members could trade their constituents' preferences for a rate cut everyone shared.

The bargain began unraveling almost immediately. The 1990 budget agreement under President George H. W. Bush raised the top rate to 31 percent. The 1993 deficit-reduction law under President Clinton raised it to 39.6 percent. Neither restored the shelters, but the core trade, lower rates for a broad base, was broken once rates went up and the preferences gradually came back. A lower rate for capital gains returned in 1990 and widened in 1997. New credits and deductions were added, year after year, for education, energy, housing and much else.

There is a fair critique from the left as well. Taxing capital gains like wages was a progressive achievement, but the top-rate cut to 28 percent helped the very highest earners a great deal, and the period that followed saw a sharp rise in income concentration at the top. Some progressives argue that 1986 helped normalize the idea that low top rates are the natural state of things. That critique has force. The law's defenders reply that it raised the effective tax burden on many wealthy people by ending their shelters, and that the drift since 1986 came from later choices, not from the law itself.

What a modern deal could borrow

It is tempting to treat 1986 as a relic of an age when bipartisanship was easy. It was not easy then; the bill nearly died repeatedly. What made it possible was a specific set of conditions: a shared diagnosis of the problem, a structure that let each side claim victory, a president willing to spend political capital on his own party and a committee chair with the skill to hold a coalition together.

A future reform could use the same shape. Both parties now complain about the complexity of the code and the benefits that flow to people who can afford sophisticated planning. A deal that ended the step-up in basis at death, curbed preferences that mainly help the very rich and used the money for lower rates on working families or a stronger child credit would follow the 1986 logic. It would also face the same enemies: every lobbyist whose client's preference was on the table.

The honest caveat is that the politics are harder now. Revenue neutrality is a tough frame when deficits are large, and both parties have staked out positions that make trading a rate for a preference look like surrender. Any prediction about whether the new Congress will attempt such a deal is speculation, and should be treated as such.

The lesson is still worth carrying. Fairness in taxation is not only about rates. It is also about whether two families with the same income pay the same tax, and whether the code rewards productive work or clever accounting. In 1986, people who disagreed about almost everything found that they agreed about that.

What you can do

Bipartisan tax reform is built from relationships and public pressure, not just proposals. Some places to begin:

• See which bills already draw both parties. The common ground page lists bills both parties passed together, a useful reminder of where agreement already exists.
• Ask your members about loopholes by name. Through the representatives lookup, contact your representative and senators with a specific question: do they support ending the step-up in basis or closing the carried-interest preference, and what would they trade for it?
• Follow the lobbyists, too. The money in politics topic page tracks reporting on campaign spending, lobbying and the interests that fight over every line of the tax code.
• Keep the distribution in view. The inequality page shows the wealth shares of the top 1 percent and the bottom 50 percent alongside real wages, the context any tax reform debate should start from.