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Do Taxes Matter? The Impact of the Tax Reform Act of 1986.

As a result of studies commissioned by the Office of Tax Policy Research at the University of Michigan, this volume consists of nine original contributions by economists presented at a conference there in November 1989 plus an introductory, overview chapter by the editor. These conference proceedings, in which each chapter is accompanied by formal comments as well as a summary of the following general discussion, represent the first systematic examination of the economic effects of the Tax Reform Act of 1986 (TRA86), the most significant change in the U.S. income tax since it was converted into a broad-based tax during World War II. Signed by then President Ronald Reagan on October 22, 1986, TRA86 generally lowered statutory tax rates and attempted to recover that lost revenue by broadening the base to reflect a more accurate definition of income. Specifically, the revenue-neutral TRA86 shifted approximately seven percent of the tax burden from households to business. For the personal income tax, revisions included a significant increase in the standard deduction and personal exemption, a reduction in the number of tax brackets and marginal tax rates, the most dramatic being the reduction in the top rate from 50 to 28 percent, and base broadening via full taxation of capital gains, elimination of the sales tax, two-earner and personal loan interest deductions and limitation of passive losses and the deductibility of IRA contributions. Similarly, changes in the corporate income tax consisted of a reduction in corporate tax rates from 46 percent in 1986 to 34 percent in 1988 coupled with base broadening in the form of the abolition of the 10 percent investment tax credit and slower depreciation schedules for equipment and business structures. Although designed to meet the mere objectives of preservation of the distribution of the tax burden across income groups and simplification of the tax system, TRA86 was widely predicted to result in significant adverse impacts on sectoral economic aggregates.

The accuracy of these predictions is addressed by the contributors to Chapters two through nine in this book with respect to investment, personal saving, corporate financial policy and organizational form, housing markets, foreign direct investment, charitable giving, state and local fiscal behavior, and foreign tax reform responses, respectively. Diverse analytical techniques, ranging from purely descriptive to time series regression are employed to ascertain whether observed changes coincide with the prior predictions. In general, the conclusion is that real economic behavior is quite unresponsive to changes in tax prices. In contrast, the timing of economic transactions and changes in the composition of individual portfolios and firms' financial claims are relatively sensitive to tax price changes. However, caution must be exercised with respect to these conclusions since they are based on at most 1986 through 1989 data and, therefore, should be considered to be preliminary and tentative.

Much public concern was expressed about the potential negative effect of TRA86 on private domestic investment. Since TRA86 increased the tax burden on new investment and shifted the tax burden from business structures to new equipment, business fixed investment, especially equipment, was expected to decrease. But Auerbach and Hasset in Chapter 2, using a value-maximizing firm model, conclude that real investment has been strong since 1986 with office, computing, and accounting machinery dominating the growth in 1986 and 1987, while investment in structures as a fraction of real GNP from 1986 to 1989 was approximately the same as that from 1980 to 1985 probably as a result of nontax factors such as technological advance, real interest rates and profitability outweighing the 1986 tax changes.

A similar conclusion is reached by Skinner and Feenberg in the next chapter with respect to personal saving. Saving was predicted to decrease as the effect of the reduction in individual marginal tax rates was over-shadowed by the increase in the capital gains tax and additional restrictions on IRA's. Regression analysis leads to the conclusions that personal saving increased as a result of the TRA86 induced decrease in the marginal tax rate on saving and that the composition of saving had shifted from personal loans to mortgage loans, because the very large capital gains realizations in 1986 did not result in increased spending, but rather in reinvestment in interest-bearing assets.

Other important macroeconomic variables expected to be affected were housing markets, foreign direct investment and charitable giving which are the subjects of Chapters 5, 6 and 7, respectively. In a purely descriptive study, Poterba finds that although reductions in marginal tax rates increased the net real cost of homeownership less than rental housing, no evidence of an increase in homeownership yet exists. Similarly, Slemrod, in another descriptive article, finds no evidence to link the boom in both inward and outward foreign direct investment with TRA86 even though this boom is consistent with low tax rate incentives. Conversely, Clotfelter does find evidence of an impact of TRA86 on charitable giving. Specifically, using four modified Feldstein models, that impact is that although aggregate charitable giving has increased since 1986, contributions have shifted away from the upper income class as it experienced the most dramatic increase in the net-of-tax cost of making contributions.

In addition to the aforementioned variables, TRA86 has impacted both the corporate and state and local government sectors and, hence, are the topics of Chapters 4 and 8, respectively. With respect to the corporate sector, Gordon and Mackie-Mason use several recent consensus models of corporate financial policy to reach the conclusions that the forecast increase in debt-to-market value of equity ratio greatly overstates the observed increase; the predicted dividend payout ratio increase actually was a decrease as a result of the larger than expected rate of corporate share repurchases; and that, in terms of legal status choice, loss firms shifted to the more highly taxed corporate sector, while positive profit firms shifted to Chapter S corporations to be taxed at the lower personal income tax rates. With respect to state and local government fiscal behavior, the expected effects of TRA86 were lower state and local spending, increased deductible taxes and user fees and a shift away from sales taxes. Instead, Courant and Gramlich found, with the most methodologically sophisticated analysis in this text, that state and local spending increased, user fees and nondeductible taxes decreased and virtually no change in deductible taxes and sales taxes occurred, even though twelve states significantly increased sales taxes after the passage of TRA86.

In a somewhat unrelated contribution in Chapter 9, Whalley descriptively examines tax reform during the 1980s in Japan, Canada, the United Kingdom, Sweden, New Zealand, Australia and Mexico in comparison with U.S. tax reform and finds broad similarities at both the personal and corporate level. Namely, all countries have consolidated personal tax brackets, reduced personal marginal rates, reduced corporate statutory rates and weakened or removed corporate investment incentives. However, although U.S. tax reform may have directly triggered foreign tax changes in the corporate tax and in countries with major investment links to the U.S., other foreign tax changes were probably the result of global common intellectual issues and political climate, rather than the result of U.S. tax reform acting as a catalyst.

In the final non-technical summary chapter, Aaron reviews the general conclusion that TRA86 has had little apparent and less than the expected effect on broad economic aggregates. In his opinion, this does not imply that tax effects are unimportant since taxpayers could expect changes to be short-lived and/or take time to adjust their behavior and/or the tax provisions may have had offsetting effects. Yet, this does imply that the behavioral elasticities are weaker and, therefore, the efficiency costs of taxation are smaller than previously believed. Consequently, counsel should be given to be relatively more attentive to the distributional aspects of the tax system.

To conclude, this compilation is concise, thought provoking and current. Unfortunately, that currency requires that caution be exercised in too quickly applying the surprisingly consistent conclusions. these results are validated by longer time series data, then an appropriate conclusion would be that current attempts by the Bush administration to alter TRA86 by restoring preferential treatment of capital gains and/or expanding eligibility for IRA's will only encourage the socially unproductive and Treasury revenue reducing taxpayer behavior of changing the timing of their transactions and/or repackaging their financial claims, rather than significantly increasing saving and investment as previously expected.
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Author:Snow, Sandra L.
Publication:Southern Economic Journal
Article Type:Book Review
Date:Jul 1, 1992
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