1986 Tax Reform Act - The Culprit

WHEN an economy has as much wrong with it as the American economy does now, the natural tendency is to list causes that match the numerous symptoms. But in fact there is one major cause for the ills of our economy: the Tax Reform Act of 1986 (TRA).

Criticisms of the TRA are not infrequent. Real estate developers (and their suffering creditors, the banks) argue that the real estate and construction slump can be attributed to the TRA. Democrats - though they were happy co-sponsors of the act - complain about the easy treatment high-income taxpayers now get.

But there are more fundamental problems with the TRA and the earlier tax reforms of the Reagan eras.

The TRA sailed through as a set of reforms that would leave tax revenues unchanged - it was "revenue neutral." This was, at least in retrospect, a startlingly irresponsible basis for making a once-in-a-generation change in the tax code, since the gap between federal income and expenditures was yawning.

The continuing budget deficit now presents a barrier - the barrier - to fiscal action that could pull us out of recession.

But the greatest evil of the TRA is long-term. It purported to produce a more neutral tax code, giving individuals greater leeway to allocate their income according to their own preferences, uninfluenced by differential tax rates. It was argued that reducing the distortions caused by the old tax code would improve allocation of resources and increase national income.

Perhaps this would have been true if we were starting from scratch in 1986, and if the TRA had more than partially eliminated distortions in our economy. Neither was true. The effect of the TRA can be seen, five years after, as increasing the bias of our system toward consumption and away from savings. The shift in taxation from personal income to business income was one of the factors contributing to this, since businesses are important savers.

While to some extent and for some time we can borrow other nations' savings, our investment rate - the key to our production and income - is heavily dependent on how much we save. The picture is not bright. In 1970 we accounted for 47.1 percent of the investment of the six largest industrial nations and 56.9 percent of their output. In 1990 our share of investment had fallen to 31 percent, and our share of output to 41.2 percent.

IN the same 20-year period high-saving Japan increased its share of investment from 19.3 percent to 34.1 percent - though half our population, the Japanese now invest more than we do - and their share of output rose from 11.6 percent to 22.5 percent. Given the strong but lagging effect of investment on output, our economic leadership in the 21st century - and the relative well-being of Americans - is already jeopardized.

Some of these problems were seen when there was still time to do the right thing. Around the time of TRA's passage, a group of economists at the Brookings Institution advocated substituting a consumption-based tax for the personal income tax. Spending would have been taxed, savings would be tax free.

That is still the best way to go. But a possibly easier and quicker step in the same direction - even if it is more Rube Goldberg than elegant - would be the institution of a value-added tax. Less cleanly than the Brookings proposals, it would shift the bias of the tax system from favoring spending to penalizing it, with a compensating relative gain for savings.

A value added tax also could be the cover for doing what was not done in 1986: providing revenue equal to the predictable spending of our federal government - without violating the supposed sanctity of our low-income tax rates.

This is not the moment to raise taxes. But as we come out of the current recession, we still have our budget deficit to worry about - as well as the long-term health and competitiveness of the American economy. Rather than fiddle with a flawed system, by adjusting capital-gains rates or by minor changes in taxes on middle-income taxpayers, we should be aiming at, alas, another major tax reform. But this time, we should get it right.