What Is the Tax Reform Act of 1986?
The Tax Reform Act of 1986 (TRA86) was landmark United States federal legislation signed into law by President Ronald Reagan on October 22, 1986, representing the most comprehensive overhaul of the U.S. tax code since the inception of the income tax in 1913. This significant piece of Tax Law and Fiscal Policy aimed to simplify the tax system, broaden the tax base, and enhance fairness and economic efficiency. The Tax Reform Act of 1986 notably reduced the number of individual income tax brackets, lowered the top marginal tax rates, and increased the standard deduction and personal exemption amounts. It also made substantial changes to corporate tax by reducing its top rate while simultaneously eliminating many tax preferences and loopholes.
History and Origin
The genesis of the Tax Reform Act of 1986 stemmed from a bipartisan desire to simplify a progressively complex tax code that had accumulated numerous special provisions, deductions, and credits over decades. President Ronald Reagan, driven by a philosophy of lower taxes and economic deregulation, made tax reform a central focus of his second term. Despite initial skepticism, a coalition of Democrats and Republicans in Congress, led by figures like Representative Richard Gephardt and Senator Bill Bradley, championed the legislation. The act was enacted on October 22, 1986, following its introduction as H.R. 3838 in the House of Representatives on December 3, 1985, and subsequent passage through both chambers of Congress.10 Its passage was a testament to a concerted effort to create a more equitable and efficient tax system by broadening the tax base and reducing individual income tax rates.9
Key Takeaways
- The Tax Reform Act of 1986 significantly simplified the U.S. individual income tax system by reducing the number of tax brackets and lowering the top individual marginal tax rate from 50% to 28%.
- It increased the personal exemption and standard deduction, removing millions of lower-income Americans from the federal income tax rolls.
- The act reduced the top corporate tax rate from 46% to 34%, but also eliminated the investment tax credit and lengthened depreciation schedules for business assets, shifting some of the tax burden from individuals to businesses.8,7
- It eliminated the preferential treatment for capital gains, taxing them at the same rates as ordinary income.
- The legislation expanded the alternative minimum tax (AMT) and significantly curtailed tax shelters and the deductibility of passive losses.
Interpreting the Tax Reform Act of 1986
The Tax Reform Act of 1986 sought to achieve greater perceived fairness and promote economic growth by reducing marginal tax rates and broadening the tax base. The idea was that lower rates would incentivize work and investment, while closing loopholes would ensure more income was subject to taxation. For individuals, the reduction in tax brackets aimed to simplify tax filing and make the tax burden more transparent. For businesses, while the corporate tax rate was lowered, the elimination of specific tax credits and changes to depreciation rules meant a higher effective tax burden for many corporations. The intent was to level the playing field across different industries and types of investments.
Hypothetical Example
Consider an individual, Jane, who had significant income from various investment income sources and also utilized tax shelters prior to the Tax Reform Act of 1986. Under the pre-1986 system, she might have faced a top marginal tax rate of 50% on her ordinary income, but her capital gains would have been taxed at a lower preferential rate, and she could have used deductions from certain passive investments to offset other income.
After the Tax Reform Act of 1986, Jane's top marginal tax rate on ordinary income would have significantly decreased to 28%. However, her capital gains would now be taxed at the same 28% rate, eliminating the previous advantage. Furthermore, many of the deductions associated with her tax shelters and passive losses would have been curtailed or eliminated, leading to a higher taxable income overall, despite the lower nominal rate. This example illustrates the shift from a high-rate, high-deduction system to a lower-rate, broader-base system.
Practical Applications
The Tax Reform Act of 1986 had profound practical implications for individuals, corporations, and the broader economy. It simplified the tax filing process for many by increasing the standard deduction, meaning fewer taxpayers needed to itemize their deductions. For businesses, the reduction in the corporate tax rate aimed to make the U.S. more competitive internationally, though the elimination of the investment tax credit and changes to depreciation schedules altered the economics of capital investment. The act also played a role in the real estate market, as changes to the treatment of passive losses discouraged certain types of investment income strategies. The changes introduced by the Tax Reform Act of 1986 were so significant that its effects on corporate investment and capital costs became a subject of detailed economic analysis.6
Limitations and Criticisms
Despite its stated goals of simplification and fairness, the Tax Reform Act of 1986 faced various criticisms. Some economists argued that while it aimed for revenue neutrality, it disproportionately shifted the tax burden from individuals to businesses.5 Critics also noted that the elimination of various deductions and credits, while broadening the tax base, could lead to unintended consequences for specific industries or investment types. For instance, the changes to depreciation and the elimination of the investment tax credit were argued by some to make the cost of capital higher in certain sectors, potentially dampening investment despite the lower corporate tax rate.4 Furthermore, subsequent legislative actions often reintroduced many of the loopholes and preferences that the 1986 act sought to eliminate, suggesting that the goal of a permanently simplified tax code proved challenging to maintain.
Tax Reform Act of 1986 vs. Economic Recovery Tax Act of 1981
The Tax Reform Act of 1986 is often compared to the Economic Recovery Tax Act of 1981 (ERTA), as both were significant tax overhauls enacted during the Reagan administration. However, their primary aims and effects differed considerably. ERTA, enacted earlier, was largely a supply-side tax cut focused on stimulating the economy through broad tax rate reductions for individuals and businesses, as well as significant acceleration of depreciation. Its primary goal was to incentivize production and investment. In contrast, the Tax Reform Act of 1986 was designed to be revenue-neutral and focused more on tax simplification and fairness. While it also lowered rates, its key characteristic was base-broadening—eliminating many deductions, credits, and preferential treatments to offset the lower rates. This meant that while ERTA primarily cut taxes, TRA86 redistributed the tax burden and aimed for a more neutral system, reducing the distorting effects of specific tax provisions.
FAQs
What was the main purpose of the Tax Reform Act of 1986?
The main purpose of the Tax Reform Act of 1986 was to simplify the federal income tax code, broaden the tax base, and reduce marginal tax rates for individuals and corporations, aiming for a more equitable and efficient tax system.
3### How did the Tax Reform Act of 1986 affect individual taxpayers?
For individual taxpayers, the act reduced the number of income tax brackets from 14 to two (15% and 28% initially for 1988), lowered the top marginal rate, and increased the standard deduction and personal exemption, thereby removing many low-income families from the tax rolls. It also eliminated the preferential treatment for capital gains and restricted many individual deductions.
What was the impact of the Tax Reform Act of 1986 on businesses?
The Tax Reform Act of 1986 lowered the top corporate tax rate from 46% to 34%. However, it simultaneously eliminated the investment tax credit, lengthened depreciation periods for assets, and significantly curtailed the use of tax shelters and passive loss deductions, effectively broadening the corporate tax base and in some cases increasing the effective tax burden.
2### Was the Tax Reform Act of 1986 considered revenue-neutral?
Yes, the Tax Reform Act of 1986 was designed to be approximately revenue neutral over the long term, meaning it aimed to generate roughly the same amount of tax revenue as the previous system. This was achieved by offsetting the revenue lost from lower rates with revenue gained from broadening the tax base and eliminating loopholes.1