Tax Reform and Revenue Neutrality: President’s Panel Should Avoid the Redistribution of 1986

Fiscal Fact No. 28

I. IntroductionPresident Bush’s Advisory Panel on Federal Tax Reform is required to recommend revenue-neutral taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform plans, meaning the new tax system should raise the same amount revenues as the current system.

As laudable as this goal is, it must be done with great care. There are good and bad ways to make a tax plan revenue neutral. The bad way amounts to raising taxes on Peter to fund tax cuts for Paul. As shown below, the Tax Reform Act of 1986 (TRA-86) – the last major tax reform enacted in the U.S – was made revenue neutral in this way, increasing the tax burden on corporate taxpayers in order to reduce the tax burden on individual taxpayers.

A good revenue-neutral tax reform plan would involve no deliberate redistribution between the corporate and individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. systems. The tax code should raise sufficient revenue to fund government programs, not act as a tool for social engineering or political patronage. Thus, the goal of tax reform is to make the tax code more simple, fair, and economically efficient by eliminating special tax breaks and applying the lowest possible tax rate on the widest possible tax base—in other words “plucking the goose as to obtain the largest possible amount of feathers with the smallest amount of hissing” as Jean Baptiste Colbert wrote some 250 years ago.

II. Overview of 1986 changesTRA-86 significantly lowered individual and corporate income tax rates while simultaneously broadening the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. by eliminating or restricting a host of individual and corporate tax preferences (exemptions, deductions, and credits). The impact of the base broadening, however, was not uniform in the individual and corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. systems. In fact, even though corporate income tax rates were reduced significantly, changes made to the corporate tax system increased revenues while the changes to the individual tax system decreased revenues. The Tax Reform Act of 1986, thus, largely used corporate base broadeningBase broadening is the expansion of the amount of economic activity subject to tax, usually by eliminating exemptions, exclusions, deductions, credits, and other preferences. Narrow tax bases are non-neutral, favoring one product or industry over another, and can undermine revenue stability. to offset individual tax reductions (see Table 1).

Table 1: Tax Reform Act of 1986 Lowered Individual Taxes and Raised Corporate Taxes

Income Tax	Five-Year Revenue Estimate
Individual	($122 billion)
Corporate	$120 billion
Total	($2 billion)

Source: Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-87).

Within the individual income tax system, the largest changes were the individual rate reductions (from 11 rates down to 2) and the expansion of the personal exemption (see Table 2). These changes were forecasted to reduce federal revenues by $329.9 billion over five years. An increase in the standard deduction (-$34 billion) and expansion of the Earned Income Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. (-$15.3 billion) also substantially reduced federal revenues. The measures that most substantially raised revenues on the individual side were the repeal of the 2-earner deduction ($27.1 billion), limitations on the deductibility of investment and personal interest ($29.4 billion), limitation on passive interest deductions aimed at tax sheltering ($36 billion) and repeal of the investment tax credit ($24.2 billion). Overall, TRA-86 was estimated to reduce individual income tax revenues by $122 billion over five years.

Table 2: Major Individual Income Tax Changes in the Tax Reform Act of 1986

Tax Code Section	Before 1986	After 1986	Five-Year Revenue Gain (Loss)
Tax-Rate Schedules	0% (0-$3,670) 11% ($3,670-$5,940) 12% ($5,940-$8,200) 14% ($8,200-$12,840) 16% ($12,840-$17,270) 18% ($17,270-$21,800) 22% ($21,800-$26,550) 25% ($26,550-$32,270) 28% ($32,270-$37,980) 33% ($37,980-$49,420) 38% ($49,420-$64,750) 42% ($64,750-$92,370) 45% ($92,370-$118,050) 49% ($118,050-$175,250) 50% ($175,250+)	15% (0-$29,750) 28% ($29,750+)1	($207.1 billion)
Net Capital Gain Deduction	Deduction for 60 percent of net capital gains	Repealed	Included in revenue loss from rate cuts
Standard Deduction	$3,6702	$5,0003	($34 billion)
Personal Exemption	$1,080	$1,900 (1987) $1,950 (1988) $2,000 (1989+)	($122.8 billion)
2-Earner Deduction	$3,000 (max)	Repealed	$27.1 billion
State and Local Sales Tax Deduction	State and local retail sales taxes fully deductible	Repealed4	$19.6 billion
Investment and Personal Interest Deductions	Investment interest: Generally deductible with limitations Personal interest: all personal interest generally deductible	Investment interest: further limited Personal interest: limited to mortgage interest on principal residence	$29.4 billion
Miscellaneous Deductions for Business Expenses	No floor on miscellaneous itemized business deductions	2% floor on miscellaneous itemized business deductions	$19.4 billion
Tax shelters	No limitation on using deductions and credits from passive losses and activities to offset other income	Deductions and credits from passive losses generally cannot offset other income	$36 billion
Investment Tax Credit	10% credit allowed for certain ACRS property	Repealed	$24.2 billion
Deductions for meals, travel and entertainment	Meals, travel and entertainment business expenses generally deductible	Meals and entertainment deductions reduced by 20 percent; travel deductions severely limited	$5.3 billion
Alternative Minimum Tax (AMT)	Tax rate of 20%	Tax Rate of 21%	$8.2 billion
Earned Income Tax Credit	Equal to 11 percent of first $5,000 of income (maximum of $550)	Equal to 14 percent of first $5,714 of income (maximum of $800)	($15.3 billion)5
Individual Retirement Accounts (IRAs)	IRA contributions deductible even if taxpayer enrolled in employer-sponsored retirement plan	Deductions for IRA contributions limited to the extent taxpayer is enrolled in employer-sponsored health plan	$23.8 billion
3-year basis recovery rule for contributory plans	Special 3-year recovery rule for annuity payments from qualified plans	Repealed	$8.9 billion
		Total Net Five-Year Impact of Major Changes on Personal Income Tax Revenues	($177.3 billion)
		Total Net Five-Year Impact of Other Changes on Personal Income Tax Revenues	$55.3 billion
		Total Net Five-Year Impact of All Changes on Personal Income Tax Revenues	($122 billion)

Source: Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-87); Pre-1986 individual tax rates: Tax Foundation Facts and Figures on Government Finance (38th Edition).

On the corporate side, the largest changes were the elimination of the top two tax rates, reduction in the middle rates (a revenue reduction of $116.7 billion), and the repeal of the investment tax credit (a revenue increase of $118.7 billion) (see Table 3). Other major changes included the increase of the corporate alternative minimum tax (AMT) rate from 15 to 20 percent ($22.2 billion), creation of uniform capitalization rules ($32.2 billion), and changes in how passive losses could be used to offset active income (-$12.6 billion). Overall, TRA-86 was expected to increase federal corporate tax revenues by $120 billion over five years.

Table 3: Major Corporate Income Tax Changes in Tax Reform Act of 1986

Tax Code Section	Before 1986	After 1986	Five-Year Revenue Gain (Loss)
Tax-Rate Schedules	15% (0-$25,000) 18% ($25,000-$50,000) 39% ($50,000-$75,000) 40% ($75,000-$100,000) 46% ($100,000+)	15% (0-$50,000) 25% ($50,000-$75,000) 34% ($75,000+)	($116.7 billion)
Capital Gains	Long-term capital gains taxed at 28% if taxpayer in bracket > 28%	Capital gains taxed at normal corporate rate	Included in revenue loss from rate cuts
Investment Tax Credit	10% credit allowed for certain Accelerated Cost Recovery System (ACRS) property	Repealed	$118.7 billion
Tax shelters	No general limitations on using deductions to offset income arising from unrelated activities	Losses from passive activities can generally only be used to offset income from passive activities	($12.6 billion)
Deductions for meals, travel and entertainment	Meals, travel and entertainment business expenses generally deductible	Meals and entertainment deductions reduced by 20 percent; travel deductions severely limited	$6.2 billion
Alternative Minimum Tax (AMT)	Tax rate of 15 percent	Tax rate of 20 percent	$22.2 billion
Installment Sales	Gain from certain property in which seller receives deferred payments reportable on installment method	Limits placed on use of installment method	$7.3 billion
Capitalization of Inventory, construction and development costs	Costs from producing property must be capitalized and offset against sales price, with different methods for different properties	Uniform set of capitalization rules	$32.2 billion
Long Term Contracts	Special accounting rules for taxpayers providing goods under contracts exceeding two (2) years	Modification of special accounting rules	$9.6 billion
Bad debt reserve for nonfinancial institutions	Deduction for losses on business debts allowed using charge-off or reserve methods	Reserve method repealed for all taxpayers except smaller commercial banks and thrift institutions	$7.4 billion
Property and casualty insurance companies	Numerous affected provisions	Numerous changes	$7.5 billion
		Total Net Five-Year Impact of Major Change on Corporate Income Tax Revenues	$81.8 billion
		Total Net Five-Year Impact of Other Changes on Corporate Income Tax Revenues	38.5 billion
		Total Net Five-Year Impact of All Changes on Corporate Income Tax Revenues	$120.3 billion

Source: Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-87).

Overall, even though TRA-86 reduced individual and corporate income tax rates, other changes in the corporate income tax system (many of them base-broadening) increased federal revenues far more than the changes in the individual income tax system. If revenue impacts of the rate reductions are removed from both the changes in the individual and corporate systems, TRA-86 raised corporate tax revenues by $237 billion but only raised individual tax revenues by $85 billion (see Table 4).

Table 4: TRA-86 Eliminated More Corporate than Individual Tax Preferences

Tax System	Five-Year Revenue Increase from Non-Rate Changes to Tax System
Individual	$85 billion
Corporate	$237 billion

III. ConclusionIf President Bush and the U.S. Congress want to truly reform the tax code, they should avoid the temptation to use revenue neutrality as an excuse to redistribute the tax burden among Americans. Specifically, they should ensure that corporate tax increases are not used to pay for changes in the individual system. In fact, Congress should go further and independently reform both systems (in a revenue-neutral manner, if necessary) rather than focus exclusively on the individual system. This could include eliminating the corporate income tax altogether or attempting to combine the individual and corporate systems in a manner that does not distort business behavior.

At the very least it will be necessary for Congress to use tax reform to lower the U.S. corporate tax rate. According to the Organisation for Economic Cooperation and Development (OECD), only two (2) out of thirty (30) OECD nations have a higher combined corporate tax rate than the U.S.6 In an era of nearly unprecedented global tax competition and disagreement with the European Union (EU) over export subsidies, it is important that Congress make our corporate tax system as competitive as possible by, among other things, reducing the federal corporate tax rate. As fomer Internal Revenue Service Commissioner Fred Goldberg Jr. said in testimony to the President’s Advisory Panel on Tax Reform, “we cannot, absolutely cannot, hope to compete in a global economy by setting corporate taxes in a vacuum. We will get killed.”7 Nor can we “hope to compete in a global economy” if Congress once again insists on an individual-corporate tax shift similar to what happened in TRA-86.

Footnotes:1. This is the rate schedule for married couples filing jointly. For singles, the 15 percent rate applied below $17,850, and for head of household the 15 percent rate applied below $23,900.

2. This was the zero bracket amount (ZBA) before the 1986 tax reform for married couples filing jointly. For singles and head of household, the ZBA was $2,480.

3. This was the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. for a married couple filing jointly. For head of household, the new standard deduction was $4,400 and for singles the new standard deduction was $3,000.

4. The state and local sales tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions. was partially reinstated as part of the American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418 (2004).

5. This figure sums the nonrefundable portion of the EITC—which is considered a tax reduction—and the refundable portion of the EITC—which is considered an expenditure. The impact on the budget baseline is the same, however.

6. See Jeffrey Owens, Fundamental Tax Reform: The Experience of OECD Countries, at 27, Tax Foundation Background Paper (February, 2005).

7. See President’s Advisory Panel on Tax Reform, First Meeting Minutes at 53 ( February 16, 2005 ) located at http://www.taxreformpanel.gov/meetings/pdf/0216_minutes.pdf.

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