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.
The complexities of the act, including the behavioral responses, that make the estimates more preliminary than usual will also make it more difficult to interpret actual collections over the next few years. In addition, the payment response to tax changes, one of the more important--and frequently overlooked--aspects of interpreting collections, must be taken into account. The tax code provides several options for satisfying requirements for timely payment of taxes and final tax liabilities, and taxpayers are given considerable latitude in choosing which option to use. At the same time, major changes in the tax law are followed by an adjustment period in which taxpayers move along a "learning curve' as they gradually adapt to the new law.
Structure of the article.--The remainder of this article discusses the major provisions of the act as they affect personal tax and nontax receipts, corporate profits tax accruals, and other categories of Federal receipts and expenditures on the NIPA basis. For personal and corporate receipts, the provisions of the act are arrayed in table 1 and discussed in order of the magnitude of their 1987 impact. At various places in the discussion, any special quarterly treatment of the impact of a provision in the NIPA's is also presented. The article is not intended to be a detailed provision-by-provision review of the act; it only serves to highlight the features of the major provisions.
Personal Tax and Nontax Receipts
Personal tax and nontax receipts are reduced $19.2 billion in 1987, $29.6 billion in 1988, and $36.0 billion in 1989. Withheld income taxes more than account for the reductions due to changes to the basic rate structure. The major change to the rate structure results from the sharp cut in the top individual income tax rate, to 28 percent from 50 percent (chart 1). (The top rate had been cut to 50 percent from 70 percent by the Economic Recovery Tax Act.) Partly offsetting the reductions in withheld income taxes are increases in declarations (estimated tax payments) and net settlements (final tax payments less refunds of the preceding year's taxes). These taxes are increased, on balance, by the elimination of various deductions, tax shelters, and preferential tax treatments, such as for capital gains income.
Basic rate structure
The act provides for a number of major changes to the basic rate structure, which, on balance, reduce withheld income taxes and declarations and net settlements. In 1987, the reductions are $33.3 billion and $17.4 billion, respectively. The major changes to the basic rate structure are from rate reductions, an increase in the personal exemption, and the replacement of the zero bracket amount with a standard deduction.
Rate reductions.--The previous 14 tax brackets (15 for single taxpayers), with rates ranging from 11 to 50 percent, are replaced by a five-bracket system, with rates ranging from 11 to 38.5 percent, for 1987 and a two-bracket system, with rates of 15 and 28 percent, for 1988 and later tax years (table 2). The 1987 rate reduction lowers withheld income taxes $17.8 billion and declarations and net settlements $15.7 billion.
In addition, the act implicitly creates a third rate of 33 percent, effective in 1988, for individuals with incomes above certain levels. Under previous laws, all taxpayers benefited from the lower rates on the first income earned. The new law, however, effectively eliminates the 15-percent tax rate for high-income individuals by imposing a 5-percent surcharge on the amount of taxable income between $71,900 and $149,250 for joint returns and between $43,150 and $89,650 for single returns. Taxpayers within these ranges will be subject to a marginal tax rate of 33 percent, but their average tax rate will not exceed 28 percent. Taxpayers with taxable income above these ranges will be subject to the 28-percent rate on all taxable income.
The taxable income bracket at which the 28-percent rate begins will be adjusted for inflation, effective for tax years after 1988. For a given tax year, the inflation adjustment is based on the increase in the Consumer Price Index (CPI) for the 12-month period ending the preceding August 31 over the CPI for the 12-month period ending August 31, 1987; if the adjustment is not an even multiple of $50, it is to be rounded down to the next lowest multiple of $50. (The rounding down in one year, however, will not affect the indexing of brackets in future years because the inflation adjustment for each year is based on the difference in the CPI applicable for that year and the CPI for the 12-month period ending in 1987.)
As mentioned earlier, the act is likely to affect taxpayer behavior, particularly because it was enacted in one year but effective in the next and later years. Two of the more significant behavioral responses resulting from this act are the deferral of income and the acceleration of deductions.
Many taxpayers, faced with a 2-year phased reduction in tax rates and the elimination--or limitation-- of many deductibles, will defer income and/or accelerate deductions to minimize taxes in 1986 and 1987. Nonwage income, such as partnership income and bonuses, may be shifted to 1987 from 1986 and to 1988 from 1987 to take advantage of the lower tax rates effective in the later years. Certain discretionary deductions, such as charitable contributions and prepaid expenses and taxes, may be shifted to 1986 from 1987 and to 1987 from 1988 to increase the tax savings from the deduction under the higher tax rates in the earlier year. These income deferrals and deduction accelerations reduce declarations and final payments in 1987. Of course, taxpayers able to take advantage of these shifts will have higher taxable incomes in later years--but taxed at lower rates--and declarations and net settlements will be increased in the later years. (These behavioral responses to the act, which are temporary in nature, are not seasonally adjusted. Instead, the effect of these behavorial responses, which is shown in table 1, is confined to the first two quarters, when most net settlements occur. The permanent effects are shown separately on a seasonally adjusted basis.)
Personal exemption.--The personal exemption is increased from $1,080 in 1986 to $1,900 in 1987, $1,950 in 1988, and $2,000 in 1989. The personal exemption will be adjusted for inflation, effective for 1990, in a manner similar to that described for the taxable income bracket. The use of the personal exemption will also be phased out for higher income taxpayers, beginning in 1988, by the 5-percent surcharge. The range over which the phase-out takes place depends on the number of exemptions. For a couple with no children, the phase-out will end at $171,090; for a couple with two children, it will end at $192,930. The 1987 increase in the personal exemption lowers withheld income taxes $17.2 billion and declarations and net settlements $3.5 billion.
Standard deduction.--The zero bracket amount--previously built into the tax rate schedules and tax tables--is replaced with a standard deduction, effective in 1987. The standard deduction, which varies according to filing status, reduces adjusted gross income in deriving taxable income. Taxpayers have the choice of itemizing deductions or taking the applicable standard deduction, whichever is higher. Personal taxes are not affected by this change in 1987, however, because the standard deduction is the same as the inflation-adjusted zero bracket amount for that year. The standard deduction is increased in 1988 to $5,000 from $3,760 (joint returns) and to $3,000 from $2,540 (single returns). The standard deduction will be adjusted for inflation, effective for 1989.
Married couples deduction.--The deduction of as much as $3,000 for married couples who both work is repealed effective January 1, 1987. The repeal increases declarations and net settlements $1.5 billion in 1987.
Income averaging.--The income averaging method, which allowed taxpayers with large fluctuations in income to reduce their tax liabilities, is repealed effective January 1, 1987. The repeal increases declarations and net settlements $0.5 billion in 1987.
Other basic rate structure provisions. --The other major provision of the act that deals with the basic rate structure is repeal of the additional personal exemption for the aged and blind. This exemption is replaced with an additional standard deduction for the aged and blind, effective in 1987. An elderly or blind married individual will add $600 ($1,200 if both elderly and blind) to the basic standard deduction; an elderly or blind unmarried individual will add $750 ($1,500 if both) to the basic standard deduction.
Pensions and employee benefits
A number of provisions affect pensions and employee benefits; the largest are a limit on the deduction for contributions to individual retirement accounts (IRA's) and a repeal of a special recovery rule for retirees.
Under previous law, all taxpayers were allowed to make annual contributions of up to $2,000 ($250 for a spouse) to an IRA, even if the individual was covered by an employer-provided pension plan. Taxes were deferred on the contributions--the contributions were deductible--and the interest or other earnings of the account until withdrawn. The act retains the deductibility of the contributions to IRA's only for single individuals with income up to $25,000, for married couples with income up to $40,000, and for all taxpayers with income over $25,000 and not covered by an employer-provided pension plan. However, for these singles with income between $25,000 and $35,000 and for these married couples with income between $40,000 and $50,000 the act phases down the amount of the deductible contribution, and it eliminates the deduction for taxpayers whose adjusted gross income before deducting the contributions exceeds the top phase-out ranges. Taxpayers not eligible for the deduction can continue to defer taxes on interest or other earnings of IRA accounts and make additional--but nondeductible --contributions up to $2,000.
The act repeals a special recovery rule that previously allowed retirees --largely public employees--to receive tax-free pensions until the payments exceeded--generally after about 18 months--the employee contributions to the retirement plan. Instead, effective July 1, 1986, the taxfree portion of the pension is spread out over the retiree's life expectancy.
These two provisions, combined with a number of others affecting pensions and employee benefits, increase withheld income taxes $3.1 billion and declarations and net settlements $1.3 billion in 1987.
The major provisions affecting business expenses limit deductions for business meals and entertainment to 80 percent of the amount spent and allow miscellaneous expense deductions, such as union dues and subscriptions to professional publications, only to the extent that they exceed 2 percent of adjusted gross income. These and other provisions affecting the deductibility of business expenses increase withheld income taxes $0.8 billion and declarations and net settlements $0.5 billion in 1987.
Consumer interest expense
The act phases out over 5 years the deduction for interest on credit cards, automobile loans, and other consumer loans except for mortgages on a principal or second residence. Interest on second mortgages is deductible, but only for loans used to finance educational or medical expenses or home improvements. Loans for other purposes cannot exceed the homeowner's cash equity for the interest to be deductible. Effective in 1987, only 65 percent of consumer interest expense is deductible, and then 40 percent in 1988, 20 percent in 1989, 10 percent in 1990, and none in 1991. This provision increases withheld income taxes and declarations and net settlements $0.7 billion each in 1987.
Other itemized deductions
The major provisions affecting other itemized deductions are the elimination of the deduction for State and local sales taxes and the increase, to 7.5 percent from 5 percent, in the amount by which unreimbursed medical expenses must exceed adjusted gross income to be deductible. These and other minor provisions increase withheld income taxes $0.7 billion and declarations and net settlements $0.5 billion in 1987.
The act repeals the preferential tax treatment of capital gains income that had been a part of the tax law since 1921. Under the act, capital gains are taxed at the same rates as ordinary income, effective in 1987, except that the top rate is limited to 28 percent in 1987. Under previous law, long-term capital gains were taxed at 40 percent of the ordinary income tax rate, which put the top effective rate at 20 percent. The increase in the capital gains tax also results in a behavioral response. Many taxpayers, faced with the increase, accelerated realizations of capital gains into 1986 to take advantage of the lower tax rate. These accelerated realizations will result in large net settlements in 1987. (This temporary effect is treated in the same manner as discussed for the income and deduction shifts.) On the other hand, it is expected that, in the long run, taxpayers will hold assets longer than they otherwise would have. Extended holding periods will tend to reduce taxes in later years; some gains may even pass through to estates and thus escape capital gains tax altogether. This and the following provisions of the act directly affect only declarations and final settlements and, on balance, they increase taxes.
Capital cost recovery system
The act repeals the investment tax credit and lengthens the time periods over which many categories of equipment and property can be depreciated. These provisions will be discussed in more detail in the corporate profits tax accruals section of the article.
The act revises the minimum tax to make it difficult for high-income individuals to combine various tax preferences to escape taxes or pay only a small amount. Any individual whose tax liability would be more under the minimum tax than under the tax rate schedule would have to pay a minimum tax of 21 percent in 1987, up from 20 percent in 1986. Taxable income for the minimum tax includes income subject to certain tax preferences specified by the act, such as intangible drilling costs or certain depreciation. All passive losses from tax shelters and other investments in which the investor does not actively participate are also added to taxable income to determine the minimum tax. Joint taxpayers can exempt $40,000 of the recalculated taxable income; individuals can exempt $30,000. The 21-percent rate is applied to the remaining amount. The exemption amounts are phased out for high-income taxpayers: They are reduced by 25 cents for each $1 that income subject to the minimum tax exceeds $150,000 (joint returns) and $112,500 (single returns). The effect of the phase-out is to increase the minimum tax to roughly 26 percent for taxable incomes in the phase-out range.
Tax shelters and real estate
A number of provisions affect tax shelters and real estate, the largest of which affects the use by individuals of losses from investments or activities in which they did not materially participate to offset wage, salary, and other investment income. Under previous tax law, high-income taxpayers would invest in apartment and commercial buildings and use losses from these investments to offset other types of income and lower their tax liability. The act eliminates, over a 5-year period, the use of these "passive' losses from pre-enactment investments. Passive losses from post-enactment investments can be offset only against income from those investments, not wage, salary, or other income. An exception is provided for individuals who have at least a 10-percent interest in rental property and actively participate in its management. Such individuals can offset against wage, salary, or other income, up to $25,000 in annual passive losses; that amount is phased out for adjusted gross incomes between $100,000 and $150,000.
Exclusions from income
The act repeals the exclusions from income for unemployment benefits, scholarship and fellowship grants, and prizes and awards. Previously, under specified conditions, a portion of unemployment benefits received under a Federal or State program was excluded from income, as were certain grants, and prizes and awards. Scholarships and fellowships are now taxable if not used for tuition or course-related books and supplies. Prizes and awards, such as the Pulitzer Prize and the Nobel Peace Prize, are now taxable unless transferred by the recipient to a government or tax-exempt organization; no charitable deduction is allowed if the prize is transferred.
Other provisions of the act increase personal taxes. These provisions, of which there are a wide variety, include a mandated calendar tax year for trusts, uniform capitalization rules, repeal of the $100 ($200 for couples filing a joint return) dividend exclusion, and taxing the unearned income of children under age 14 at the parent's top marginal tax rate.
Estate and gift taxes, which are included in NIPA personal tax and nontax receipts, are reduced by a provision allowing an estate to exclude 50 percent of the qualified receipts from the sale of employer securities to an employee stock ownership plan or to an eligible worker-owned cooperative. The provision applies for sales made after the date of the enactment and before January 1, 1992.
Corporate Profits Tax Accruals
Corporate profits tax accruals are increased $32.7 billion in 1987, $25.4 billion in 1988, and $27.5 billion in 1989. Rate reductions, effective July 1, 1987, lower corporate taxes; however, a large number of provisions increasing taxes more than offset the rate reductions.
Basic rate structure
The act revises the basic rate structure for corporations and, on balance, reduces corporate taxes $9.7 billion in 1987. The major change to the rate structure is a replacement of the five-bracket system, with rates from 15 to 46 percent, by a three-bracket system, with rates of 15 to 34 percent (table 3). The act also provides an additional tax of 5 percent on corporate income over $100,000, up to a maximum additional tax of $11,750. This additional tax--similar to the personal surcharge --implicitly creates a 39-percent rate and operates to phase out the benefits of the lower tax rates for corporations with taxable incomes between $100,000 and $335,000. A corporation with taxable income of $335,000 or more will not benefit from the lower rates applied to the first $75,000 and will be taxed at the 34-percent rate. Because the rate reductions are effective July 1, 1987, a corporation with a tax year including this effective date will calculate its tax under both the old and new tax rates and then prorate the old and new taxes to that part of the year proportionate to the part of the year that precedes or follows the effective date. (In the NIPA's, corporate taxes are reduced in the first quarter of 1987 because the basis for tax liability is the calendar year. An average tax rate is derived from the calendar year tax liability and taxable profits. The quarterly pattern is then derived using the average calendar year tax rate and quarterly taxable profits.)
Capital cost recovery system
The largest tax increase provided by the act results from repeal of the investment tax credit and a modification of the accelerated cost recovery system (ACRS) of depreciation for businesses. These provisions increase corporate taxes $14.3 billion in 1987; combined with the effect on personal taxes, the increase is $19.0 billion. Repeal of the investment tax credit, first placed in the tax law by the Revenue Act of 1962, had been a major provision of every version of tax reform considered in the past 2 years. The ACRS, when placed in the tax code by the Economic Recovery Tax Act of 1981, had been considered the cornerstone of efforts to revitalize American industry and a spur to economic growth; it was designed to encourage business investment by shortening the period over which equipment and property could be fully depreciated.
The 10-percent investment tax credit (6 percent for certain short-lived assets) was repealed, effective January 1, 1986. The act also provides that 82.5 percent of unused credits-- unused because profits were smaller than available credits--can be carried forward to offset taxes in 1987 and that up to 65 percent can be carried forward in later years. Previously, the full amount of unused credits could be carried forward 15 years or back 3 years. The act maintains the credit for property that qualifies as transition property. Generally, a property qualifies as transition property if it was "constructed, reconstructed or acquired' under a binding contract by December 31, 1985, and was placed in service according to a specified schedule. Transition rules also apply for motion picture or television films and for certain sale-leasebacks. The act also provides for a credit carryback for qualified steel companies and farmers.
The modification of the ACRS lengthens the period over which assets can be depreciated. While the act lengthens the depreciation period, it also provides that, in most cases, the assets can be depreciated under a 200-percent, rather than a 150-percent, declining balance method. Taxpayers may use the modified ACRS rules for property not covered by transition rules and placed in service after July 31, 1986, and before January 1, 1987. These rules are mandatory for most tangible depreciable property placed in service after December 31, 1986.
The modified ACRS assigns property lives in eight classes, from 3-year property to 31.5-year nonresidential real property. Automobiles and light trucks are depreciated over 5 years, compared with 3 years under previous law. Most types of manufacturing equipment are depreciated over 7 years, compared with 5 years under previous law. Some types of longer lived equipment are depreciated over 40 years. For most types of equipment, depreciation is calculated using a 200-percent declining balance method, allowing faster depreciation in the first years after an investment, compared with a 150-percent declining balance method under previous law.
Residential rental property is depreciated over a 27.5-year period using the straight-line method, compared with 19 years under previous law. Nonresidential real property is depreciated over a 31.5-year period using the straight-line method, compared with 19 years under previous law. Sewage treatment plants and telephone distribution plants are depreciated over 15 years, using the 150-percent declining balance method. Sewer pipes and certain other long-lived equipment are depreciated over 20 years, using the 150-percent declining balance method.
The act also allows small businesses to depreciate as much as $10,000 of equipment in a single year. This "expensing' allowance is phased out for businesses investing more than $200,000 a year.
As designed, the modified ACRS increases taxes over the long run; however, it is expected to reduce taxes in the first 2 years after enactment because of the use of the 200-percent declining balance method and because of the transition rules. Under the transition rules, the modified ACRS system does not apply to specific types of property placed in service after 1986 when the property meets one of five specified exceptions as of March 1, 1986.
A number of changes to accounting rules provide the second largest increase --$14.2 billion in 1987--to corporate taxes. Within this category of changes, the largest increase is due to the establishment of uniform rules to determine what costs and expenditures can be capitalized. These new uniform rules apply to all real and tangible property produced by a taxpayer or acquired for resale. The rules apply, however, only to property used in a trade, a business, or activity that is profit oriented. They do not apply to timber or to property produced under a long-term contract, where special rules apply. In general, the rules require that costs attributable to inventory (such as for insurance and inspection) be added to costs of producing the inventory and that costs attributable to producing or acquiring other property (such as a portion of repair and maintenance) be capitalized. The effect of the uniform rules is that taxpayers will not be able to claim current deductions for costs that now have to be included in inventory or capitalized.
The act limits the use of the installment-sales method of deferring tax liability. The use of the installment method of accounting has been prohibited or limited in the following ways: (1) It is prohibited for revolving credit sales--when the customer agrees to pay a portion of the outstanding balance of an account on a periodic basis--and for sales of stock or securities traded in established securities markets, and (2) it is restricted when used for income from sales of real property and for sales by dealers of personal property.
The act disallows deductions by nonfinancial businesses for reserves held to cover bad debts. Deductions are allowed only when specific loans become partially or wholly worthless.
Other accounting provisions prohibit the use of cash accounting by financial institutions, simplify the LIFO inventory method for certain small businesses, and require that public utilities using accrual accounting report income at the time services are provided instead of when billed.
The act revises the minimum tax to make it more difficult for large and profitable businesses to escape taxes or pay only a small amount. An important new feature of the revised minimum tax is the use of reported "book income' as a separate test of taxability. Under the new provision, a corporation calculates taxable income under current law, using all deductions, exemptions, and exclusions. Then, these adjustments, as well as other specified adjustments, are added back to taxable income to derive an alternative minimum taxable income. The corporation then compares this minimum taxable income with book income reported, for example, to stockholders. If book income is more than the minimum taxable income, one-half of the difference is added to the minimum taxable income. The minimum tax is then calculated on the total at a tax rate of 20 percent, compared with 15 percent under previous law. After 1989, the "book income' feature will be replaced by a minimum tax on a corporation's adjusted current earnings.
An exemption of $40,000 is provided for small businesses with small amounts of adjustments, but the exemption is phased out for those businesses with more than $150,000 of minimum taxable income.
The act repeals a special deduction of 20 percent of certain income of life insurance companies, institutes the discounting of the deduction for loss reserves of property and casualty insurance companies in order to account for the time value of money, and repeals the tax-exempt status of Blue Cross-Blue Shield and certain other companies. These and other provisions affecting insurance companies are generally effective January 1, 1987.
Employee stock ownership
The act repeals, effective January 1, 1987, a payroll-based credit, limited to one-half of 1 percent of compensation, available to employers who participated in employee stock ownership plans. The credit was previously due to expire after 1987.
Among a variety of provisions, the act limits tax write-offs for U.S. businesses for interest on loans made in the United States that benefit overseas operations and limits the use of foreign tax credits to shelter passive income earned abroad.
The act limits deductions for business meals and entertainment to 80 percent of the amount spent.
Research and development
One of the few tax reductions for corporations, other than for rates, is an extension through 1988 of the tax credit for increased spending for research and development; this credit expired at the end of 1985. The act, however, reduced the credit to 20 percent from 25 percent and tightened the definition of research and development. The act also provides--effective January 1, 1987--a new 20-percent credit for 3 years for corporate contributions to or contracts with universities or nonprofit organizations to conduct research and development.
The act limits the deduction that commercial banks with assets of $500 million or more can use to cover delinquent loans. In addition, the existing reserves of large banks must be "recaptured'--added to income over a 4-year period. Under the act, banks can only use the deduction when actual losses are incurred. The act also eliminates an 80-percent deduction that financial institutions previously used to offset interest payments made on borrowings in new investments in tax-exempt securities.
The act taxes capital gains as ordinary income, effective January 1, 1987, with special transition rules for the first year.
General Utilities rule
The act repeals the "General Utilities' rule, named for a Supreme Court decision that has been interpreted to mean that no gain is realized upon corporate distributions of appreciated property to its shareholders. Under the act, the interpretation no longer holds; gains from the liquidation of assets are now taxed.
The major provision affecting tax-exempt bonds is one that reduces the ability to earn arbitrage, which involves using funds raised from the sale of tax-exempt securities to buy taxable securities carrying higher interest rates. The tax-exempt bonds provisions are generally effective for bonds issued after August 15, 1986.
Tax shelters and real estate
The tax shelter and real estate provisions that increase personal taxes are expected to provide more corporate investment opportunities. Investments made less appealing to individual taxpayers because of limits on passive losses may be undertaken by a corporation that would actively participate in the activity. That participation will generate deductible expenses, such as interest, and therefore lower tax liabilities.
Other provisions, on balance, increase corporate taxes. The major increase results from a new capitalization rule for State and local taxes. For example, the amount of sales tax paid on the acquisition of depreciable property will be added to the basis of the property and treated as part of the cost for depreciation purposes. Under previous law, the sales tax was deductible. Also, corporate taxes are reduced a small amount by a provision modifying the targeted job credit.
Other Receipts and Expenditures
The act provides for a number of changes to excise taxes, including a new 10-percent nondeductible excise tax on employers receiving assets from reversions of employee retirement plans, effective January 1, 1986. Also, effective January 1, 1988, the liability for the gasoline excise tax will be shifted from the wholesaler to the manufacturer. This shift is expected to reduce the amount of gasoline tax that was evaded in the distribution stages. Contributions for social insurance are increased by the provision restricting meals and entertainment expense; the self-employed social security contribution will increase because income after expenses will be higher.
The act also has a direct impact on Federal Government expenditures-- on the NIPA basis as well as in the unified budget--by increasing the earned income credit, which is available to low-income workers with a dependent child. Effective in 1987, the maximum credit is $800, up from $600. The credit is reduced by 10 percent of an individual's adjusted gross income or, if greater, earned income, in excess of $6,500. No credit is available when an individual's adjusted gross income or earned income exceeds $14,500. Beginning in 1988, the credit phase-out will begin at $9,000 of adjusted gross income (or, if greater, earned income), with no credit available when income exceeds $17,000.
Table: 1.--Impact of the Tax Reform Act of 1986 on Federal Government Receipts and Expenditures, NIPA Basis
Table: 2.--Individual Income Tax Rate Schedule for Joint and Single Returns Under the Tax Reform Act of 1986
Table: 3.--Corporate Income Tax Rate Schedule
Photo: CHART 1 Top tax Rate for Individuals and Corporations, 1910-90
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|Author:||Wakefield, Joseph C.|
|Publication:||Survey of Current Business|
|Date:||Mar 1, 1987|
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