The 1986 tax reform law was proposed by the Reagan administration as a way to simplify the federal income tax and make it more “fair” by reducing the legal loopholes that had been built into the tax over the prior seventy years. The law was designed to reduce the number of tax brackets to only three, while also eliminating the number of ways individuals and corporations could reduce their tax bills by manipulating income, expenses, and deductions. The administration wanted to reduce the existing 15 marginal tax brackets that ranged from 11 to 50 percent, to only three brackets of 15, 28, and 31 percent. The proposed reforms were in line with what tax economists had been advocating for several decades, i.e. create a tax system with a base as broad as possible and rates as low as possible.
Expanding the tax base by reducing special treatment of some types of income has the advantage of treating all income earned in the same way, rather than giving preference to some types of income and not to others. Examples of tax preference are the treatment of capital gains, oil depletion allowances, and real estate investments, each of which has been taxed more favorably than wage and salary income. The base can also be expanded by reducing the number of expenditures that can be deducted before arriving at a taxable income value. For example, the 1986 law eliminated personal deductions for sales taxes and interest paid on consumer debt, while also restricting the ability to deduct medical and dental expenses.
The broadest possible tax base is obviously a tax on all income, from whatever source, with no allowable deductions, exemptions, or exclusions. Such a tax base is not practical because of the difficulty of discovering and taxing small amounts of income, as well as the problem of simply defining what constitutes income. Wages and salaries received are fairly easy to identify, but income from personal businesses, rental property, and sales of personal assets is more complicated. Expenses incurred in the process of earning an income are generally considered legitimate deductions in arriving at taxable income, so income derived from a business would be sales revenue minus allowable expenses such as cost of materials and supplies, wages paid, etc. But many complications of the tax law arise from attempts to identify clearly what expenses are deductible and which are not deductible.
The 16th amendment to the constitution defined income to be included under the law as “income from whatever source derived”, which implies that all income earned should be treated as equal under the tax law, regardless of how it is earned or how it is spent. But changes to the law over the years have created the most complicated and cumbersome tax system that could be imagined. While the actual tax law now requires volumes of print, the Internal Revenue Service explanations and rules under which the law is administered require many times more words and volumes. Most tax experts believe no single individual can now be expected to be knowledgeable about more than a small portion of the law and its interpretation. It should be no surprise that one of the fastest growing businesses in America
Every attempt by Congress to “simplify” or “reform” the federal income tax results instead in the creation of thousands and thousands of new pages of law, and hundreds of thousands of new IRS rules and regulations. While economists favor broad based, low rate taxes with minimal impact on individual economic decisions, Congress uses the income tax system to stimulate desired activities and to restrict undesired activities. Republicans increasingly want to use the tax system to stimulate economic growth and new jobs by eliminating the tax on “investment” income such as dividends and capital gains, but such a “reform” would have the primary impact of reducing or eliminating taxes for the wealthiest taxpayers, while having very limited impacts on growth and jobs.
Capital Gains
One of the biggest controversies in the tax reform debates involves whether or not to treat income from realized capital gains as ordinary income, or in a special category with lower tax rates. Few issues in taxation evoke such heated controversy, dissolve party loyalties, or pit so clearly liberals against conservatives as does capital gains. But few issues are so inherently political in nature because arguments on both sides sound so logical but produce such widely varying impacts. And few issues have so much potential for dividing the electorate between the haves and the have-nots.
A capital gain is the realized financial gain on the sale of an asset designated by Congress as a “capital” asset. The most common examples are real estate, stocks, and bonds, but Congress has also designated assets such as vacant land, trees, and dairy cattle as “capital” assets eligible for special tax treatment. If an investor purchases a capital asset for $1,000 and sells the asset for $2,000 after more than one year, the sale qualifies as a “long-term” capital gain. The maximum tax on long-term gains is now 15 percent, so the taxpayer would pay a maximum of $150 on the $1,000 gain. Low income taxpayers in the 10 percent bracket would pay only 10 percent tax, but few taxpayers in that bracket ever report taxable capital gains.
During the 2012 Presidential campaign, every Republican candidate for President proposed some form of capital gains tax reduction, ranging from complete elimination of all tax on capital gains, to a rate reduction, to a reduction of capital gains for all taxpayers earning less than $250,000 a year in total income. The arguments in every case were to stimulate economic growth, create jobs, and generate additional income tax revenue over time, but the actual impacts are likely to be more limited.
History of Capital gains taxation
For all tax years between 1921 and 1986, and again since 1993, sales of capital assets that resulted in long–term gains received special treatment under the tax law. While the definition of "long–term" and the applicable tax rates have changed periodically, the principle of preference has been maintained. Before the 1986 law, sixty percent of any long–term gains could be excluded from tax, making the maximum effective tax rate on such gains only 20 percent (50 percent maximum tax rate times 40 percent of the gain). In 1993, the maximum tax rate on capital gains was set at 28 percent, and then reduced to 20 percent in 1997, even though rates on other income were as high as 39.6 percent. The maximum was reduced again in 2003 to only 15 percent.
The stated goal of tax reform in 1986 was two–fold. First, broaden the tax base by taxing all income equally, and second, lower tax rates on all income. To that end, rates were reduced and restructured to include only three brackets and such preference items as the special capital gains treatment and passive income losses were eliminated. The impact on long-term capital gains was to increase the maximum effective rate from 20 percent to the 33 percent rate that applied to all ordinary income. But while reformers won the 1986 battle, they did not win the war.
Proponents of preference argued that treating capital gains like wages and salaries was not only unfair, it also reduced incentives to invest in productive capital and thereby hindered economic growth. It was unfair because part of any long–term gain results from accumulations over time, and it was unfair to tax gains as though they occurred in the year the asset was sold. Furthermore, part of any gain realized over time was the result of inflationary increases in asset values, and not really a gain at all. And any increase in effective tax rates was argued to decrease incentives to save and invest and therefore decrease capital investment and risk taking.
Reformers, however, argued there were also several problems created by the special treatment of capital gains in the past. The first was that accumulations from a period as short as seven months were treated the same for tax purposes as those that accumulated over forty years. In what sense does an asset bought and sold within the same calendar year result in a "long–term" gain that should require preferential treatment?
A second problem was the appropriate definition of a "capital" asset. In economic terms, capital is an asset used in the production process to assist in creating goods and services. Items such as factories, equipment and machinery are capital goods. But Congress has expanded that definition to include, for tax purposes, essentially any asset that was not used for consumption. It has included vacant land, financial assets, property rights, trees, dairy cows, and whatever else enterprising taxpayers could get Congress to include.
The 1986 tax law satisfied hardcore reformers by treating all gains as ordinary income, but it decreased incentives to invest in productive capital. It offered halfway reform, but in solving one equity problem it created new problems in both equity and efficiency. The 1993 law reestablished some tax preference for capital gains, and Republicans, led by President George W. Bush, have lowered the maximum tax on capital gains to only 15 percent. A more thorough reform to restore both efficiency and equity would end preferential treatment while still encouraging investment in productive activities. The solution involves three steps.
First, the tax law should define capital in the strict economic sense of productive assets, and then treat all gains from the sale of such capital as ordinary income. Second, allow income averaging for any gains that were the result of accumulations of one year or more. With the law now having only six tax rates, such averaging would have relatively little revenue impact, and would improve equity at little cost. Third, allow indexing of all gains to adjust for the portion of any gain that was created by inflation, thereby subjecting to tax only the real value of any gains.
Narrower definitions of capital assets would prevent most of the abuses created by the current preferential system, but would still encourage investment in productive assets. It would also stop the rewarding of speculation in assets such as vacant land, antiques, and contracts where no production occurs, since gains on such assets would not be eligible for indexing or averaging. Such investments may yield high returns, but they are not so desirable as to merit public encouragement and the same tax treatment as investment in factories, equipment, and machinery.
President Bush originally proposed a 15 percent long term capital gains rate in 2001. This would restore the preference system of the past in an attempt to restore incentives to save and invest, but would do so by restoring large tax benefits to the few who enjoy long–term capital gains. The top 1 percent of taxpayers claim over half of all capital gains, making the rate reduction clearly a benefit tilted toward the very rich. Congressional opponents proposed a smaller rate reduction and a long run indexing system. While both proposals dealt with part of the issues, neither would result in equitable treatment of long–term capital gains compared to earned income while increasing incentives to invest.
Tax equity prohibits the granting of new preferences to capital gains and demands that income from property be treated the same as income from labor. But equity also requires that gains earned over a long period not be taxed the same as income earned in a single year. And efficiency requires that investment funds be encouraged to move quickly and easily into productive areas where assets can be used most efficiently.
The most difficult step in the reform process was taken in the 1986 law, but reversed only seven years later. Treatment of gains as ordinary income is actually the most radical reform of all. But modifying that reform to narrow the definition of capital and to include indexing and averaging of gains on productive capital would complete the reform process by further improving both tax equity and productive efficiency.
Next: The Impact of Eliminating Capital Gains Taxes
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