America's Fiscal Constitution (51 page)

When evaluating calls for tax reform or “closing loopholes” within the context of the fiscal crisis in the early twenty-first century, it is worth recalling some of the consequences of the celebrated 1986 tax reform.
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Congress reduced personal income tax rates by imposing higher taxes on investment income, even though by the late 1980s national savings rates had fallen to a historic low. Immediately after the Tax Reform Act of 1986 raised the tax rate applied to capital gains, pressure mounted to lower it.

The act also produced an unintended consequence that haunted the budgets of Reagan’s successor, George H. W. Bush. Commercial real estate prices and development collapsed after the legislation eliminated tax shelter incentives. Borrowers could not make payments on real estate loans, triggering claims on federal deposit insurance for savings and loans that would soon cost more than $200 billion.

From the end of the Korean War in 1953 through 1989, personal income taxes as a share of adjusted gross income ranged from a low of 11.5
percent in 1965 to a high of 15.7 percent in 1981.
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During the Reagan administration the effective tax rate fell in the middle of that range. In the 1980s the share of gross income paid in federal personal income tax by the half of American taxpayers with the lowest incomes fell from 6.2 percent to 5.1 percent; the corresponding share for taxpayers with the highest incomes fell from 17.3 percent to 14.5 percent.
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Most taxpayers did not experience a net reduction in federal taxes, however, because they paid higher payroll taxes in support of dedicated trust funds.
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The other major revenue source for the federal funds budget—corporate income taxes—stagnated largely as a result of international competition. Federal leadership failed to either identify a replacement source of the revenues provided by corporate taxation or curtail the spending that had once been sustained by corporate taxation.

A M
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Americans have never liked to pay taxes. Ways and Means Chairman Robert Doughton noted early in the Korean War that everyone “wanted to do their full part in producing the revenue necessary . . . [but] claimed that any additional revenue should come from some other source.”
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The total payroll tax supporting pensions and Medicare hospitalization was scheduled to rise to 15.3 percent of covered payroll in 1990, an amount considered to be the upper limit by all federal leaders in each party.
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So when Secretary of Health and Human Services Otis Bowen began exploring how Medicare could cover longer hospital stays, hospice care, and expensive prescription drugs, federal officials agreed that any new such services should be financed by taxes on the people who would be eligible for those benefits. The idea of a debt-financed expansion of Medicare remained far outside the political mainstream.

Passage of the Medicare Catastrophic Coverage Act of 1988 initially appeared to be a bipartisan triumph much like the Tax Reform Act of 1986. Medical providers and the American Association of Retired Persons endorsed the legislation’s expansion of coverage paid for with a new tax on high-income seniors.

Yet many Medicare beneficiaries became enraged upon learning that the law required retirees to pay a higher share of Medicare costs, even though the tax applied only to beneficiaries with high incomes. Congress repealed the act in 1989. Politicians and budget officials squarely confronted the
inevitable dilemma: if payroll taxes for Medicare Part A had reached their tolerable limit, and retired Americans would not pay premiums greater than 25 percent of the cost of Medicare Part B, who would pay the other 75 percent of the program’s escalating costs?

Congress did not repeal a provision of the Medicare Catastrophic Coverage Act that required state-administered Medicaid programs to pay premiums and copays for seniors with very low incomes. Many seniors with long-term disabilities, such as dementia, would soon rely on this dual eligibility to pay for long-term, institutionalized care. Within a decade, seven million people with dual eligibility accounted for an annual cost of $50 billion from Medicare (24 percent of Medicare costs) and $63 billion from Medicaid (35 percent of Medicaid costs).
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Medicaid had evolved from the grant programs originally backed by conservative Robert Taft and the American Medical Association. By the late 1980s the program become a means of paying for long-term care for impoverished elderly and disabled Americans. This role for Medicaid in part reflected the modern sensitivity to the plight of citizens with age-related disabilities.
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The federal mandate that required the use of matching state funds to pay Medicare premiums for Americans in nursing homes did, however, squeeze state budgets. Bill Clinton, governor of Arkansas, expressed the frustration of other governors when he criticized the federal attempt to obtain “universal coverage using the states’ credit cards as the financing mechanism.”
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By the end of the Reagan administration, tax policy had reached a stalemate. By then federal leaders in both parties acknowledged the importance of avoiding the distortions caused by the highest marginal tax rate. Republicans never defended debt-financed tax reduction as a matter of principle, yet they allowed the historical bond between spending and tax policies to fray. In 1988 Vice President Bush beat back a strong primary challenge from Bob Dole using a television ad attacking the senator for refusing to sign a pledge against higher taxes. Bush promised to limit future borrowing with a “flexible freeze” on federal spending. Bush courted antitax activists by punctuating his vow to oppose any tax increase with the phrase “read my lips.”
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After Bush won the 1988 presidential election, former presidents Nixon, Ford, and Carter privately advised him to close the budget gap with a combination of lower spending and higher taxes. The president-elect also had to decide how to respond to the ongoing work of the National Economic
Commission, created by Congress and chaired by Drew Lewis, a former corporate executive and Reagan cabinet member, and Robert Strauss, a former chairman of the Democratic National Committee. Lewis and Strauss worked quietly to develop consensus balancing the budget by cutting spending and raising tax revenue. But in 1989 Bush refused to repudiate his tax pledge.

Bush’s own cabinet wanted more flexibility and less freeze when he tried to implement the campaign promise of a “flexible freeze” on federal spending. Secretary of Housing and Urban Development Jack Kemp wanted to revitalize affordable housing programs. Secretary of Defense Dick Cheney asked for a larger military budget, and Secretary of State James Baker argued for financial assistance to help the Soviet Union move toward a market economy and a closer relationship with the West. The president himself championed federal leadership in making higher education more accessible. A spending freeze with so many exceptions was not so different from budget business as usual.

Ways and Means Committee Chairman Rostenkowski met with the president-elect shortly after the election. The chairman promised to give Bush a one-year grace period for pressing new tax legislation, but House Republicans gave the president little leeway. Despite a large deficit, they tried to cut the tax rate on capital gains. Senate Democrats felt betrayed when the president endorsed the House-sponsored tax legislation rather than considering tax legislation only as part of any overall plan to balance the budget.

Many senior economic officials pushed for a return to traditional budget discipline. Federal Reserve Chairman Alan Greenspan warned that he would not expand the money supply to finance continued deficits. Budget Director Richard Darman, a powerful figure in the Bush White House, explained the stakes: “Our deficits are disproportionately financing current consumption rather than investment in future productive capacity. . . . And unless this is corrected, our long-term economic future cannot be what Americans have traditionally hoped for and expected.”
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Federal borrowing appeared to be out of control. The president—at heart a traditional fiscal conservative—had had enough of what he once termed “voodoo economics.”

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1990–2000: Years when deficits exceeded debt service = 7 (1990–1996, structural deficit)

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Ways and Means Chairman Dan Rostenkowski and President Bush had starkly different political pedigrees. Bush was a Connecticut Yankee, the Yale-educated son of a Republican investment banker and US senator, while the Polish American Rostenkowski had learned politics from his father, an alderman in Chicago’s Democratic machine. But they had some shared experiences. Both had been superb young baseball players and also were rookies in 1965 on Wilbur Mills’s powerful team, the House Ways and Means Committee. They liked and trusted one other.

On March 6, 1990, Rostenkowski told Bush that he intended to get the ball rolling on a plan to close the budget gap. Rostenkowski’s proposal—which included a freeze on all cost-of-living adjustments for federal benefits and a higher gasoline tax—would undoubtedly generate controversy. Budget realities and a sense of responsibility for the nation’s future soon moved the president to do more than watch Rostenkowski’s initiative from the sidelines. A slowing economy and obligations arising from federal deposit insurance had pushed projected deficits to record levels. Without congressional action, the Gramm-Rudman-Hollings debt ceilings would soon require the president to sequester an estimated $100 billion appropriated by Congress for the following fiscal year.
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That spring Bush invited
congressional leaders from both parties to a series of White House budget meetings.

Progress stalled. Democratic senators refused to make any new budget proposals until the president publicly endorsed the elements of a realistic plan to balance the budget. On June 26, 1990, the White House released a statement calling for “entitlement and mandatory program reform; tax revenue increases; growth incentives; discretionary spending reductions; orderly reduction in defense expenditures; and budget process reform.”
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Although the president’s chief of staff, John Sununu, tried to distinguish “tax revenue increases” from higher taxes, Bush could not deny the clear implication of his statement. That shift produced turmoil in the ranks of House Republicans, many of whom learned first from journalists about the demise of the “read my lips” campaign promise.

Previous presidents had carefully rallied public support for balanced budgets by unambiguously stating that peacetime borrowing threatened the nation’s future. The sacrifices required to actually balance the budget and the record of the Reagan administration required Bush to finesse the issue.

After secret negotiations, acrimonious debate, a brief shutdown of the government, and an initial defeat in the House, Congress passed and Bush signed the Omnibus Budget Reconciliation Act of 1990. The act affirmed the influence of the traditional fiscal constitution while also revealing a challenge from some House Republicans who preferred to tolerate deficits—a form of deferred taxation—rather than vote for an immediate tax increase. They were led by Newt Gingrich, a former Rockefeller Republican who had become a partisan hero after bringing down Democratic Speaker of the House Jim Wright in 1989. In the 1990 budget negotiations Gingrich told Budget Director Richard Darman that he intended to discredit the federal government, including President Bush, and “in four years” ride the resulting backlash to the House speakership.
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In doing so, Gingrich forced the president to give greater weight to the priorities of House Democrats in order to muster a congressional majority.

The Omnibus Budget Reconciliation Act of 1990 raised revenues and set multiyear limits on annual growth in federal funds spending for defense and all domestic programs except for those funded by formula, such as Medicare. It also significantly reformed budget procedures. One portion of the legislation—the Budget Enforcement Act of 1990—allowed
members of Congress to block proposed new appropriations or tax legislation that would raise spending or lower revenues relative to annual targets.

The Budget Enforcement Act proved to be the single most effective budget reform since the Budget and Accounting Act of 1921. It required Congress to confine defense appropriations and a large portion of domestic spending to annual ceilings.

The Congressional Budget Office (CBO) projected that the Omnibus Budget Reconciliation Act of 1990 would cut federal borrowing by almost $500 billion over five years compared to the benchmark of “business as usual.”
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The CBO estimated that the act reduced planned growth in defense spending by $125 billion, raised various sales taxes and user fees by slightly more than $100 billion, limited Medicare payments by $37 billion, and increased both income taxes and payroll taxes by $40 billion.
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The act’s effectiveness was not immediately apparent, however, since its adoption coincided with a recession, spiraling costs of deposit insurance for savings and loans, and a spike in Medicare spending for home health care. The 1990 budget agreement did, however, create a framework for the restoration of fiscal discipline in the ensuing decade.

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