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February 7, 2013
Stanley Surrey Knew a Thing or Two About Loopholes
Joseph J. Thorndike

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In the annals of 20th-century tax policy, Stanley Surrey looms large, not least for his invention of the tax expenditure concept. But Surrey's contributions were more than simply theoretical. They were rooted firmly in his knowledge of tax politics and of all its real-world messiness. Long service in Washington gave Surrey a deep understanding of the policy process, and this proved crucial to his efforts at improving it.

Consider, for instance, Surrey's appreciation for the power of loopholes as both a legislative reality and a political construct. He understood, of course, the imprecision of the term. "The use of the appellation 'loophole' is a matter of viewpoint," he wrote in a 1957 study of the subject.1 "What is a 'tax loophole' to a CIO [Congress of Industrial Organizations] or an ADA [Americans for Democratic Action] meeting is merely 'relief from special hardship or intolerable rates' to an American Bankers Association or NAM [National Association of Manufacturers] meeting -- and vice versa."

But Surrey also understood the political and rhetorical power of loopholes, especially as opposed to more polite, precise, and anodyne alternatives like "tax preferences." More to the point, he understood that special tax provisions -- his generic term for narrowly targeted tax provisions granting special treatment to discrete groups of taxpayers -- posed a threat to the integrity of the income tax. "The situation is a serious one, and the solutions are far from clear," he warned.

Surrey's study of loopholes, and the legislative process that produced them, bears revisiting today -- not simply because it tells us something about tax policy in the 1950s, which it does, but also because it reminds us of the daunting challenge that is tax reform today.

A Grand Achievement

Surrey began his study of the tax legislative process with a paean to the income tax and the lawmakers who created it. Congress had shown "remarkable collective wisdom" in shaping the revenue system, he insisted. The progressive income tax was among the most difficult of all taxes to create and administer, making congressional success even more remarkable.

A progressive income tax is also the most complicated and difficult of taxes to maintain. It places a premium on sensitivity to economic changes and to public attitudes. It demands high technical skills on the part of those who shape the legislative structure, who administer and interpret its provisions, and who advise the public on how to order its business and family affairs under the tax. It requires a literate citizenry with a respect for law and a willingness to shoulder fiscal burdens.

But if Americans deserved credit for building a workable tax system, they couldn't be allowed to rest on their laurels. The income tax of 1957 was rife with problems, Surrey warned. In particular, lawmakers had shown a growing fondness for "provisions granting special treatment to certain groups or individuals." Some of these provisions were old, he pointed out, while others were quite new. But collectively they were growing, both in number and fiscal impact.

Surrey cited a few examples of undesirable special provisions: (1) the "exceedingly preferential treatment of capital gains" and especially the extension of this treatment to employee stock options, pension trust terminations, coal and timber royalties, patent royalties, agricultural crops, livestock, and other types of income; (2) percentage depletion; (3) the exemption for interest on state and local bonds; (4) the "continual expansion of deductions for personal expenses unrelated to profit-seeking activities"; (5) the exemption for many fringe benefits; and (6) special tax benefits for the blind and elderly.

Obviously, some of these loopholes were hardly deserving of the name, if by loophole we mean something inadvertent, narrowly targeted, or both. Indeed, some of Surrey's offending provisions were very deliberate and very broad.

But all fell afoul of Surrey's test for identifying undesirable special tax provisions: They all violated canons of horizontal equity, or what Surrey called simply fairness. "The income-tax burden should as far as possible apply equally to persons with the same dollar income," he wrote. Yet these provisions -- and many others -- impeded that goal.

An Opportune Moment

Surrey's interest in loopholes was both prescient and illuminating. These were the early years of the unholy compromise that has marked the income tax for much of its modern history: the backdoor reduction of nominal rate structures through the creation of numerous tax preferences.

We remember the 1950s for the high statutory rates left over from World War II. Economists of the era were nearly unanimous in decrying these rates, arguing that they were inefficient and impossible to administer. Republican political leaders, for their part, had been urging their reduction since the war ended.

But high rates survived the end of World War II, and later survived the end of the Korean War, too. Even after Republicans captured both the White House and Congress in the 1952 election, the rates remained stubbornly high, thanks chiefly to President Eisenhower's abhorrence of deficits and devotion to debt retirement.

Notably, however, while statutory rates remained high, average rates were falling. As various scholars have pointed out, erosions of the tax base (and extensions of capital gains treatment) had reduced effective rates for almost all taxpayers, especially those with income in the upper brackets.2

This phenomenon -- the persistence of high statutory rates and the proliferation of preferences -- struck many observers as the worst of both worlds. And Surrey took it as his starting point. "The high rates of the individual income tax, and of the estate and gift taxes, are probably the major factor in producing special tax legislation," he observed. "This is, in a sense, a truism, for without something to be relieved of, there would be no need to press for relief."

But Surrey took his analysis a step further, questioning the legislative honesty of the arrangement. "The average congressman does not basically believe in the present rates of income tax in the upper brackets," he wrote. "When he sees them applied to individual cases, he thinks them too high and therefore unfair." As a result, these lawmakers were inherently receptive to arguments that the operation of these rates created a "special hardship" that was "penalizing" a particular taxpayer. (Such phrases, Surrey noted wryly, were drawn from "the tax lobbyist's approved list of effective phrases.")

Special provisions were the most natural solution for lawmakers dubious about high rates but unwilling to take the political risk of repealing them, according to Surrey. Other countries had witnessed a similar phenomenon. "A sort of political paralysis appears to be forming in countries relying strongly on income taxation under which no clear way has appeared to move away from the combination of high rates tempered by many avoidance possibilities," he wrote.

The solution, of course, seemed obvious even then: rate reduction paired with simultaneous base broadening. Today we think of that as the classic formulation of tax reform. But it's worth remembering that such a definition is not timeless. Rather, it is historically specific, growing up at a specific time and in a specific place. In the United States, classic tax reform is a phenomenon of the postwar decades, with deep roots in the 1950s and real but incomplete legislative expression in the 1960s, 1970s, and 1980s.

But even Surrey -- one of the original champions of this kind of tax reform -- understood that rate reduction paired with base broadening was no easy lift, at least among lawmakers. In fact, it was a solution without a champion. Politicians on both sides of the aisle had reason to stay away. Conservatives, for their part, worried that marginal rate cuts for wealthy taxpayers would prove politically toxic, even if average tax rates remained steady. Conservatives also worried that once rates were cut and preferences pared, political pressure would send rates climbing again -- and make them much more painful.

Liberals were likewise lukewarm to tax reform. Left-leaning lawmakers "fear that they cannot persuade their supporters to accept tax rate reductions for the wealthy in such clear terms as reduction of a ninety percent rate to fifty percent or sixty-five percent, especially when the starting rates are high and the compensating factor is merely the closing of a number of loopholes which the public cannot understand," Surrey said.

Surrey's tax reform dilemma sounds remarkably familiar, describing as it does the current state of affairs in Washington. Obviously, lawmakers did find a way around this obstacle in 1986. But the fears Surrey described among both conservatives and liberals seem to have been realized in the decades since. Many of today's conservatives feel betrayed by the 1986 bargain, pointing to the rate increases that followed. And liberals seem just as convinced that loopholes are a fact of life: Eliminate them one year, and they come roaring back the next. The game is not worth the candle when well-heeled lobbyists can simply re-create any loophole in short order -- and enjoy newly low tax rates at the same time.

Which leaves the status quo intact. And as Surrey's article reminds us, that status quo is old indeed. It may have disappeared for a little while, but the Reagan-era success was exceptional. Which is not to say that a repeat is impossible. Certainly, there are still a few legislators out there who seem to be keeping the flame alive.

But the dynamics of tax policymaking in a democracy do not make Surrey-style reform very easy. Or very permanent. And the limited success of 1986 probably puts it even further out of reach today.


1 Stanley Surrey, "The Congress and the Tax Lobbyist -- How Special Tax Provisions Get Enacted," 70 Harv. L. Rev. 1145, 1148 (May 1957).

2 For a discussion of these rates, see Marc Linder, "Eisenhower-Era Marxist-Confiscatory Taxation: Requiem for the Rhetoric of Rate Reduction for the Rich," 70 Tul. L. Rev. 905 (1996); William V. Williams, "The Changing Progressivity of the Federal Income Tax," 17 Nat'l Tax J. 425 (1964).