Martin Feldstein: The Tax Reform Evidence From 1986

Mr. Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, is a professor at Harvard and a member of The Wall Street Journal's board of contributors.

Congress's Joint Select Committee on Deficit Reduction is struggling to find $1.5 trillion in cuts over the next 10 years. This is a unique opportunity to use tax reform to reduce future budget deficits while lowering individual tax rates.

The Tax Reform Act of 1986, enacted 25 years ago last Friday, showed how a tax reform that includes lower rates can change incentives in a way that grows the tax base and produces extra revenue. The 1986 agreement between President Ronald Reagan and House Speaker Tip O'Neill reduced the top marginal tax rate to 28% from 50%. A conservative Republican and a liberal Democrat could agree to a dramatic reduction in top rates because the legislation also eliminated a wide variety of tax loopholes....

To measure that response, I studied a sample of individual tax returns (stripped of all identifying information) for more than 4,000 taxpayers provided by the U.S. Treasury Department. Because the sample contained the tax return of each individual for the years 1985 through 1988, I could compare the taxable income of individuals in 1985 with their taxable incomes in 1988, two years after their rates were lowered.

Taxpayers who faced a marginal tax rate of 50% in 1985 had a marginal tax rate of just 28% after 1986, implying that their marginal net-of-tax share rose to 72% from 50%, an increase of 44%. For this group, the average taxable income rose between 1985 and 1988 by 45%, suggesting that each 1% rise in the marginal net-of-tax rate led to about a 1% rise in taxable income....