The Tax Reform Act of 1986
The Tax Reform Act of 1986 was one of the major accomplishments initiated by the Reagan Administration, passed by a Democratic House and Republican Senate. One of the most important pieces of tax legislation since WWII, it sought to "level the playing field" by curbing tax shelters, lowering corporate tax rates, and eliminating special treatment for capital gains. Thereafter, capital gains, earned income, and unearned income were all taxed at the same rate. In economists' language, it brought the average marginal tax rates on labor and capital income closer together.
Since 1986, other tax legislation has again increased taxation on earned income to a higher rate than that on capital gains, which again received preferential status. While the top rate on capital gains remained at 28%, the top earned income tax rate was increased to 31% in 1991 in a package endorsed by President Bush as a tactic for addressing burgeoning federal deficits. This violated his "Read my lips...No new taxes." campaign pledge as was thought to be a factor underlying his defeat in the 1992 elections. In 1993, under President Clinton, the earned income rate climbed even higher, to 39.6%.
Other features of the Tax Reform Act of 1986:
- Tax cut. The top marginal tax rate on wealthiest individuals was reduced 44% (from 50% percent to 28%). The marginal rates for leass wealthy individuals were also reduced, but not by as high a percentage. Tax reductions were said by some critics to underly the massive mushrooming of the federal deficit during the Reagan administration.
- Tax base. The tax base was broadened as fewer individuals and businesses were allowed to escape taxation.
- Tax simplification. Tax laws were simplified.
- Investment tax credit repeal. The investment tax credit for purchase of depreciable assets was eliminated. Both short term depreciation schedules and the use of accelerated depreciation were eliminated, setting new cost recovery periods of 27.5 years for residential rental property and 31.5 years for nonresidential property. This, along with new passive loss limitation rules, caused a sharp decline in the use of tax shelters by the wealth. (The passive loss limitation rule disallowed losses from activities in which the taxpayer did not materially participate as a current deduction against all sources of income except for other passive activities. )
- IRA deductions. The tax deduction for contributing to an Individual Retirement Account (IRA) was eliminated for high-income taxpayers.
- Bank deductions for bad debts. From 1969 to 1986, for corporate income tax purposes banks could deduct from their income allocations to loan-loss reserves. The Tax Reform Act of 1986 allowed this practice to continue for banks with $400 million or less in total assets but larger banks were restricted to deducting only actual loan-loss charges during a given year.
Tax reform is technical and complex, giving rise in the debate over the Tax Reform Act of 1986 to the following well-publicized quote: "Very frankly, Madam Speaker, I respectfully submit there is not a person alive who knows what is in this bill." -- Rep. Stan Parris (R-VA), Congressional Record, 25 Sep 1986, p. H-8375
Source: D. Garson, with permission.