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

July 13, 2005

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

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 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

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 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.


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