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 tax 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 tax 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 base 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 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 broadening to offset individual tax reductions (see Table 1).

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

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 Credit (-$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

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

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

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 deduction 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 deduction 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.