Tax-Break Proposals Threaten Reform : Changes Sought in 1986 Act May Unravel in Face of ‘Bidding War’

WASHINGTON —  Three years after the Reagan Administration and Congress overhauled the tax code in a historic agreement to curtail deductions and reduce rates, that compromise appears to be in danger of coming unglued as the Bush Administration and members of Congress advance proposals to restore major tax breaks.

“We’re in big trouble,” said Robert McIntyre, who played an important role in popularizing the case for tax overhaul. McIntyre, the director of Citizens for Tax Justice, a liberal advocacy group, said the risk is rapidly growing that a “bidding war” will erupt between the White House and Capitol Hill over who can offer the most generous tax breaks--with one likely result being a tax system skewed in favor of the rich.

The development marks a turnaround from earlier this year, when most analysts derided prophecies that the Tax Reform Act of 1986 might unravel.

At the time President Bush initially proposed restoring tax breaks for capital gains and oil investments, his proposals did not seem to be going anywhere, in part because of congressional determination to preserve the act’s integrity.

Girding for Battle

Now, however, the House Ways and Means Committee has narrowly approved a capital gains tax reduction bill, and Democratic opponents of the measure are girding for battle on the House floor and in the Senate by introducing their own tax-break proposals, notably an expansion of the tax benefits for individual retirement accounts (IRAs). Meanwhile, the Treasury Department has disclosed that it is studying a host of tax changes aimed at encouraging savings and investment.

As a result, “it seems to me that the pundits who said tax reform wouldn’t last long may be right,” said John E. Chapoton, a Washington attorney and former top tax official in the Reagan Treasury.

Chapoton said he does not expect the 1986 act to fall apart completely, but critics of tax overhaul, such as Republican political analyst Kevin Phillips, smell blood.

“Public opinion polls show that the electorate never cared for it,” Phillips said. “Now we’re seeing the framework for a confrontation between the parties on the (tax) issue, and that will make it harder to maintain the truce.”

Defenders of the 1986 act say the assault on the landmark legislation could introduce new instability in the tax code even before the act’s provisions have been fully phased in. The result, they say, could also reverse the greater tax “progressivity” created by the 1986 act, meaning that a smaller share of the total tax burden would fall on the rich and a greater share on other income groups.

U.S. Competitiveness

Advocates of the recent proposals to change the law retort that the changes are needed to boost U.S. competitiveness.

The Treasury said in a statement that a tax break for capital gains “is an incentive for efficiency and productivity” and “should not be lumped into a category with unnecessary tax loopholes” that the 1986 act was supposed to eliminate.

In a like vein, Senate Finance Committee Chairman Lloyd Bentsen, D-Texas, the chief proponent of restoring tax benefits for IRAs, said his proposed deduction “isn’t a loophole. This is an incentive for savings that’s terribly important.”

Tax overhaul was based on a bargain: Rates would be lowered significantly for almost everyone--especially for the rich, who saw their top rate reduced to 28%. This was less than half the 70% that prevailed at the beginning of the decade. In exchange, many deductions and credits would be wiped out--with the rich again affected disproportionately because they tend to lose the most from the elimination of investment incentives and other such tax breaks.

Effort to Raise Tax Rate

The Democratic leadership is considering launching a major effort to raise the top tax rate on the rich to 33% to offset the benefits of lower capital gains taxes. For now, Bush’s opposition to a tax increase poses a big obstacle to such a move. But eventually, rates will have to rise if tax breaks are reinserted in the code, warned Sen. Bill Bradley, D-N.J.

“The agreement of reform was, eliminate loopholes and lower rates,” said Bradley, a key architect of the 1986 act. “If loopholes re-enter, then that will put very strong pressure on rates.”

The current wave of tax-break proposals is not expected to cause anything like a quick return to the pre-1986 code. Many of the most important elements of the 1986 act appear untouchable at least for now, including the elimination of the corporate investment tax credit and the limits on the deductibility of consumer interest expense.

The Old System

But tax-overhaul supporters say they fear that reviving a couple of juicy tax breaks will begin a process of moving back toward the old system that politicians will find difficult to resist.

“Once you’ve breached the dike, there’s really no end to it,” said a Ways and Means Committee Democratic aide.

A good example of this syndrome may be the Democrats’ efforts to counter Bush’s capital-gains tax cut by offering the alternative of an expanded IRA deduction.

Led by Bentsen, the Democratic IRA boosters contend that their proposals would provide much less of a bonanza to the rich than would the capital-gains bill approved by the Ways and Means panel. (The Ways and Means bill would provide tax cuts averaging $24,906 for individuals with incomes over $200,000, and $270 for individuals in the $20,000-to-$30,000 income class, according to congressional estimates.)

Politically Irresistible

But there is a good chance that instead of substituting the IRA proposal for the capital gains proposal, Congress will find both of them politically irresistible, many political analysts believe.

That could happen despite the fact that tax cuts would seem to threaten Congress’ ability to meet the $100-billion budget deficit target set for fiscal 1990 by the Gramm-Rudman-Hollings law. The reason is that Bentsen has designed his plan to phase in gradually, with the revenue loss to the Treasury occurring in the years after 1990.