The Tax Reform Act of 1986

Survey of Current Business, March, 1987 by Joseph C. Wakefield

The Tax Reform Act of 1986

THE 1980's will be viewed by historians as a decade of significant changes in the U.S. tax code. As the decade began, the Economic Recovery Tax Act of 1981 put in place one of the largest tax reductions in history. In the next few years, other major tax legislation--including the Tax Equity and Fiscal Responsibility Act of 1982, the Social Security Amendments of 1983, and the Deficit Reduction Act of 1984--increased taxes, either to reduce mounting budget deficits or to restore the solvency of the social security trust fund. Most recently, the Tax Reform Act of 1986 put in place the most sweeping revision in the history of tax law. It provides for major reductions in the top tax rate for individuals and corporations; the individual top rate for 1988 will be the lowest since 1931. It reverses a 20-year erosion in the tax burden of corporations. It repeals or limits many of the tax credits and deductions that encouraged certain kinds of investment. Although it does not significantly redistribute the tax burden between high- and middle-income taxpayers, it abandons steeply progressive tax rates--once considered crucial to achieving an equitable income distribution--but compensates by limiting the tax preferences heavily used by higher income taxpayers. Finally, the act reduces the tax burden at the lower and of the income spectrum.

The Tax Reform Act was passed by Congress on September 27, 1986, and signed by the President on October 22, 1986. Most of the provisions of the act were effective January 1, 1987; a few were retroactive to January 1, 1986, and some are phased in over the next few years. The act was designed to be revenue neutral over a 5-year period; that is, the act neither increases nor decreases Federal Government receipts compared with the previous tax law. This neutrality was achieved by offsetting large reductions in individual and corporate income tax rates with a broadening of the tax bases by the elimination of various deductions, tax shelters, and preferential tax treatments, such as for capital gains. According to the Department of the Treasury, the act reduces unified budget receipts $5.4 billion over fiscal years 1987-91. Receipts are increased in 1987 and 1988 and reduced in 1989-91; receipts are increased in the early years because most of the provisions increasing taxes, such as repeal of tax preferences, are effective in early 1987 while those reducing taxes, largely changes to the corporate tax structure, do not occur until later.

Preliminary estimates.--The estimates of the impact of the act on the national income and product account (NIPA) basis shown in table 1 should be viewed as preliminary. The act is very complex, and many of the provisions are interactive and are likely to bring about major changes in taxpayer behavior. In order to portray the ultimate effect of a tax proposal on receipts, the Office of Tax Analysis (OTA), in the Department of the Treasury, made considerable effort to take into account behavioral responses in preparing the data on which the NIPA estimates are based.1

1. For a more detailed discussion of the procedures underlying the OTA data, see H.W. Nester, "Interpreting Revenue Estimates: Macro-Static/Micro-Dynamic' to be published in the forthcoming proceedings of the 79th annual conference of the National Tax Association-Tax Institute of America, November 1986.

However, estimating behavioral responses, such as the deferral of income and the acceleration of capital gains realizations to take advantage of lower tax rates, encounters several difficulties. The most obvious is the lack of data and/or the necessary empirical work to determine relevant elasticities. In other instances, when both empirical research and theory indicate the direction and magnitude of a response, information on the timing and pattern may be lacking. It will take time to accumulate the evidence needed for more exact estimates.

A second reason for viewing the estimates as preliminary is that they reflect a historical relationship between withheld income taxes and tax liability. The estimates of the impact of the individual rate reductions are not based on the new graduated withheld income tax tables, which were not available at the time OTA prepared the data, and reflect the incremental adjustment of withholding allowances that most individual taxpayers followed in the past to reach a satisfactory level of withholding. However, the historical relation is not fully appropriate because the new Form W-4 --the Employee's Withholding Allowance Certificate used by employers to determine the amount of withholding from pay--is designed to bring withholding closer to tax liability than in the past and because taxpayers are required to file a new Form W-4 no later than October 1, 1987 that reflects their revised withholding allowances.

Furthermore, evidence since the OTA data were prepared indicates that underwithholding occurred when the new tax tables were initially put into effect on January 1, 1987. The underwithholding resulted from the use of the new tax table in combination with the number of allowances-- based on marital status and number of exemptions--on file for 1986. The 1986 allowances were used by employers in calculating the initial 1987 withholding because most employees had not yet filed a new Form W-4. Many higher income taxpayers need to reduce their number of allowances to be consistent with the provisions of the new law and the initial underwithholding will lessen as they do so.