What is the central components of the Tax reform act of 1986

What is the central components of the Tax reform act of 1986?

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Solution

The Tax Reform Act of 1986, signed by President Ronald Reagan, was one of the most significant changes to the American federal income tax system.

The Tax Reform Act of 1986 had several noteworthy components, not the least of which was the reduction in the number of tax brackets (from a little over a dozen down to four) and the reduction in the top tax rate (from 50% to 28%). It also eliminated the deductibility of interest on consumer loans(such as credit card debt) and reduced the amount of depreciation deductions companies could generally claim. Surprisingly, before the Tax Reform Act of 1986, taxpayers were not required to prove that the children they were claiming tax deductions for actually existed (today taxpayers must provide the child\'s Social Security number on the tax return).

The Tax Reform Act of 1986 was projected to raise corporate taxes by more than $120 billion over the 1986 to 1991 period. Actual federal corporate tax receipts in the last five years have fallen far short of these projections. This paper explores the factors that have contributed to this shortfall. The most important factor is lower-than-expected corporate profits. The underperformance of corporate profits can be attributed to three principal causes. First, the predicted rates of corporate profits when the 1986 Tax Reform Act was enacted were high by historical standards. The total returns on corporate capital in the U.S. economy in the late 1980s were not as high as the pre-1986 forecasts which underlay initial revenue projections. Second, corporate interest payments were significantly higher, as a share of corporate operating income or GNP, in the late 1980s than in the years leading up to the Tax Reform Act. This reduced the corporate tax base, and may in substantial part ultimately be attributable to the marginal incentive effects for debt and equity finance provided in the 1986 Tax Reform Act. Third, also quite likely in reaction to recent tax changes, the last few yearshave seen rapid growth in the income reported by Subchapter S corporations. This income is taxed under the individual income tax. The rise of S corporations has, therefore, contributed to the erosion of the corporate income tax.

Corporate tax receipts during the last five years have fallen significantly below projections that were made when the Tax Reform Act of 1986 was enacted. These projections called for a substantial increase in corporate taxes during the last half of the 1980s. Actual corporate tax receipts have barely equalled the level projected in early 1986, before passage of the tax reforms that were expected to increase revenues. The most important factor in the corporate tax shortfall is lower-thanexpected corporate profits. The underperformance of corporate profits can be attributed to three principal factors. First, the predicted rates of corporate profits when the 1986 Tax Reform Act was enacted were high by historical standards. The total returns on corporate capital in the U.S. economy in the late 1980s were not as high as the pre-1986 forecasts which underlay initial revenue projections. Second, as a share of corporate operating income or GNP, corporate interest payments were significantly higher in the late 1980s than in the years leading up to the Tax Reform Act. This reduced the corporate tax base, and may, in substantial part, ultimately be attributable to the marginal incentive effects for debt and equity finance provided in the 1986 Tax Reform Act. Third, also quite likely in reaction to recent tax changes, the last few years have seen rapid growth in the income reported by Subchapter S corporations. This income is taxed under the individual income tax. The rise of S corporations, therefore, has contributed to the erosion of the corporate income tax. The most important unsettled issue this paper raises is how to calculate the net revenue effect of the various behavioral shifts described herein. A decline in corporate profits that results from higher interest payouts reduces corporate income tax revenues, but at the same time may increase the tax collections from interest recipients. A similar shift in the labeling of revenue occurs when enterprises choose to become Subchapter S corporations. It is essential to net the decline in corporate taxes against the increase in other taxes in evaluating the revenue effects. This requires a set of assumptions about the marginal recipients of interest payments, and about the types of activity that are shifted between C and S corporate status. Further research is needed to provide such models. The experience of the last several years underscores the elasticity of taxable income flows among different labels with different tax characteristics. When the tax code places different burdens on debt and equity or S and C corporate income, some taxpayers are likely to respond by rechanneling their taxable income. The elasticity of such financial flows is far greater than the behavioral elasticities, say of labor supply or saving, because the real effects associated with financial relabeling are less substantial than those with changing a factor such as labor supply.