The US Tax Reform Act of 1986 has been praised by the leaders of both parties, from the intellectual “founder” of the idea, the moderate Democratic senator Bill Bradley, to Ronald Reagan, the most conservative president in recent memory, who made it the chief domestic policy goal for his second term. Proponents of the bill said it would make the tax code both fairer and simpler, by lowering tax rates for the common man and curtailing a wide variety of special deductions, credits, and loopholes that the rich had used to avoid paying their fair share of tax.

The bill was also promoted as a boon to the working poor—six million lowincome taxpayers will be taken off the tax rolls entirely—while remaining “revenue-neutral,” i.e., providing neither more nor less income to the government. But those who have had high expectations for the bill are in for a shock. Not only does it amount to a substantial tax cut for many of the rich, but it also contains hidden dangers to the idea of equal opportunity in America.

The new bill replaces the current system of fourteen tax brackets ranging from 11 percent to 50 percent with only two tax brackets, 15 percent and 28 percent.1 This is a clear step backward for the progressive idea of taxation—that the rich should pay a greater share of the tax burden. The current system is only mildly progressive, because many upper-income taxpayers have used deductions and shelters to pay less than their nominal rate of tax.2 But the new law is a gift to the rich unmatched since Calvin Coolidge pushed through a 24 percent top rate for 1929. In the new law, the top rate also extends far down into the middle class; single taxpayers begin paying a marginal 28 percent on every dollar earned over $17,850. Thus, for example, a science researcher making $22,000 a year pays the same 28 percent marginal tax rate as Lee Iacocca, who makes over $1,000,000 a year.

The new low rates create a windfall in tax savings for those taxpayers making over $200,000 a year who didn’t take advantage of many deductions or tax shelters; their top tax rate falls from nearly 50 percent to 28 percent. For example, a stockbroker earning $500,000 a year who paid 40 percent, or $200,000, in federal tax in 1986 gets a $60,000 cut to 28 percent, paying $140,000 on the same income in 1988. Such taxpayers make up only 0.3 percent of the total but will, in 1988, save $19.7 billion in taxes, according to the Joint Committee on Taxation—an astonishing 32 percent of the bill’s benefits to individuals in that year. For a government facing huge budget deficits, this is a large gift to bestow on an already privileged part of the population. It is only partially balanced by $17.3 billion in increased revenues expected from those in this income class who are giving up shelters and other deductions.

By contrast, the cost to the government of relieving six million poor people from the obligation to pay any federal income tax is only $2 billion. And the effect of the law is only to restore late 1970s’ real rates of tax on these poor taxpayers. Not that the government ceases taxing these people altogether—they and their employers are subject to social security tax, currently 7.15 percent and scheduled to increase later in 1987. For many of the working poor, this is a large portion of the taxes they have been paying and, because of the high cost to employers, it is an economic threat to the creation of low income jobs. Finally, the new law actually penalizes 1.7 million taxpayers earning less than $10,000 a year, who see their tax rate rise from 11 percent to 15 percent; the average tax increase for this group will be $214 in 1988, a substantial amount for anyone earning less than $10,000.

To return to the rich, those with incomes over $200,000 who previously managed to keep their tax bill low will have to scramble to avoid sharp tax increases. But we can expect that these taxpayers have the means and the ingenuity to do just that. Failure to act would mean an average $55,700 tax increase in 1988 for this 0.2 percent of the taxpaying population, who, for example, exploited tax shelters—investments in which the taxpayer does not participate actively in management, such as a limited partnership for construction of an office building—that yielded losses used to write off actual income. The new bill generally allows deduction of shelter, or passive, losses only against earnings from other passive investments.

The trick for rich investors who can afford it is that passive losses may be carried forward into future years until passive income is found. For example, a taxpayer may have participated as a partner in two tax shelter schemes: one, a complex of rental apartments in Coral Gables, Florida, and another, a cattle deal in Wyoming. In the first several years, the apartment complex, which is still under construction, provides the taxpayer with passive losses; these may total $30,000 in 1988. The cattle ranch is not yet profitable so it also generates $30,000 in losses. Under the new law’s transition rules, only 40 percent of these losses can be used to reduce the taxpayer’s 1988 taxable income. So he can lower his income by only $24,000, compared to the full $60,000 under the old rules. However, the unused $36,000 in losses can, if the investor has enough capital to meet interest and other costs, be used in later years to offset the income that would result when the apartments get built, the cattle deal becomes profitable, or when the taxpayer disposes of his interest in either.


Some real-estate entrepreneurs who manage properties may be able to claim their income as passive, and thus use it to offset their losses. It is also possible for a well-heeled taxpayer to buy shares in profit-producing passive investments, such as a city parking lot or a block of rental units. If he can keep borrowing to a minimum, our taxpayer may, for example, be able to obtain $36,000 in income from his shares in a new parking lot in 1989 or 1990, and can offset that income with the $36,000 in losses carried over from 1988. Thus, in effect, our taxpayer builds his equity in the apartments and obtains additional income from the parking lot, all of it tax free.

Such benefits are available only to those who can afford to purchase passive income; a middle-income taxpayer with little cash to spare just has to take his losses and hope his investment makes a profit or can be sold soon. For the well to do, other choices also exist. They can buy tax-exempt bonds, for example. The well to do will also benefit because the new bill broadens the category of investment income. Under the old law, a rich investor with $300,000 in income from investments such as stocks and bonds, royalties, or venture capital stock could deduct up to the amount of investment income—$300,000—in interest costs incurred in borrowing money for these and other investments. The new bill adds long-term capital gains and income and loss from certain working oil and gas interests into the category of investment income. Thus if the well-off investor takes a $200,000 long-term capital gain on sale of stock in 1988, and maintains his income from other investments at 1986 levels, he will be allowed to deduct a full $500,000 of the interest he paid to borrow money for investment that year, enabling him to expand his holdings significantly, while deducting interest costs. This preferential tax treatment won’t be available to taxpayers without the capital to generate substantial investment income. So the rich will stay rich, while much of the middle class will have to struggle to stay afloat.

The elimination of tax shelters provides only a part of the revenue that was required to make the bill revenue-neutral. The lowering of rates is expected to cost $120 billion over the five years to 1991, and as the House-Senate Conference Committee approached its recess deadline of August 16, the revenue estimates by the committee’s staff kept coming up short of expectations. Yet the lawmakers never considered raising the rates;3 instead they continued to seek new sources of revenue. This was accomplished at a price, of course. As Senator John Danforth, the Missouri Republican who voted against the bill after initially supporting it, said:

The whole nature of the bill, right from the outset, has been that we in the Congress have become—and myself included—intoxicated by the low rates. We have been willing to do anything to accomplish low rates. We were willing to dump more and more taxes on our industrial sector, on research and development, on education in order to placate this god that we had formed of low rates.

The bill’s treatment of heavy industry provides an example. The auto, steel, chemicals, and textile industries are already in decline and are struggling to remain competitive with imports. Yet the bill eliminates the investment tax credit, a 6 percent or 10 percent credit for equipment purchases which many of these companies relied on, and makes equipment depreciation schedules less generous. The bill also lowers the corporate tax rate from 46 percent to 34 percent, but this benefits primarily service companies that don’t invest heavily in plant and equipment and that currently pay high tax rates, such as retailers, whole-salers, consumer-product companies, and various other service firms. The apparently unintended result could be a sharp blow to American industry. As Danforth noted: “I think we should strive for a balanced economy, and for a country that can make things and for an industrial sector which can compete with the rest of the world. I do not think we should shove them over the cliff. I believe that is what this bill does.”


Tax lawyers and economists, three months after passage of the bill, admit that they are confused about the effects of the legislation on the economy. To collect more revenue, the bill eliminates some tax credits, alters depreciation schedules, and changes accounting rules—whose effects only time will make evident. Tax lawyers do agree, however, that the new bill is anything but a simplification. The new law has led to frenetic activity among tax advisers, and many aspects of the bill remain to be interpreted by the Treasury Department and the Internal Revenue Service.

Clearly, however, education in the US could be heavily damaged by the provisions of the new bill that are intended to raise revenue. The bill no longer allows interest costs on most loans, including student loans, to be deducted. It thus effectively increases the cost of borrowing for higher education, just when students are becoming more and more dependent on borrowing large sums of money to attend expensive colleges and universities. The bill also inexplicably taxes scholarships and fellowships. This rule will particularly hurt graduate students, especially if they have families to support, since the remainder of their small stipends not used for tuition or books and equipment will be taxed.

Of course, the main provision of the bill, its lower rates, hurts both education and charities simply because the value of the deduction given to a charitable or educational institution is reduced. At a 50 percent tax rate, a $500 gift to a university yields a $250 benefit. At 28 percent, the same $500 gift will yield only a $140 benefit. John Brademas, president of New York University, has said the new law will reduce charitable contributions to higher education by as much as $1.2 billion annually. It is likely that other nonprofit organizations will also be unable to raise as much money as they had previously done.

The bill also makes fund raising for colleges and universities more difficult by imposing a stiff new minimum tax on gifts of appreciated property, such as stocks, bonds, and valuables. Such property makes up about 40 percent of all charitable contributions made to universities, and some donations will be reduced since they will no longer be fully tax deductible for the donor. The bill also no longer allows charitable contributions to be deducted by those who do not itemize deductions. In addition, the bill imposes a new institutional limit of $150 million on tax-exempt bond issues by private universities. This will hurt especially the leading research universities, many of which are well above that amount and rely heavily on such bond issues to raise money to build new laboratories and other facilities. The limit does not apply to public institutions, however, which retain full rights as governmental entities. The new bill thus strikes a particular blow at private institutions.

Middle- and upper-middle-income parents trying to save money for their children’s education will also have their task made more difficult by the new bill. Previously, parents as a means of saving for tuition expenses were able to shift to the child an unrestricted portion of their income every year, to be taxed at the child’s lower rate. Under tax revision, shifting income to children, at the child’s rate, will be limited to the first $1,000 every year until the child is fourteen, at which time parents can begin setting aside larger amounts of money in a fund for the child’s education. So parents making full use of tax-advantaged saving for a child can at most set aside $14,000 in investment income earned in the child’s account by the time the child turns fourteen. With costs of a four-year education rising rapidly and nearing $80,000 at the best private schools, and already between $25,000 and 30,000 at many state-supported schools, this provision seriously curtails the ability of a middle- or upper-class family to save for a child’s education.

The treatment of other individual deductions draws a sharp line between those who own property and those who do not. The bill no longer allows deductions for any debt interest not tied to a mortgage. It also disallows state and local sales taxes and limits other widely used deductions, including employee business expenses such as professional journals, continuing education courses, union and professional dues, job-hunting expenses, work uniforms, and tax and investment advising services. Medical expenses allowed for deduction are also reduced; in 1987, only those costs over 7.5 percent of gross income may be deducted compared to 5 percent previously. These are deductions taken by many middle-class taxpayers, who will either have to cut back on them or face, in some cases, sharply higher tax bills. Those who don’t own property will be hit hardest, since almost all deductions available to them are curtailed, while the bill preserves full deductibility of mortgage interest on first and second homes, as well as on all property taxes.

Homeowners also will be able to borrow under the new law and deduct their interest costs by refinancing their homes, or taking out a second mortgage. For instance, a couple who bought a house for $50,000 twenty years ago and have added $30,000 in improvements will, under the new law, be able to borrow up to the original value of the house and the improvements, or $80,000, for any purpose, and deduct the interest expense from their taxes. If the house is now valued at $300,000, the couple may borrow up to that value, or an additional $220,000, for educational and medical expenses. Renters, even if they could borrow such sums from a bank or another source, will effectively pay more than their propertied counterparts because they cannot deduct the interest costs on such loans. Here the bill again evidently favors the home-owners who make up much of the middle class, and this is part of its political appeal; but what has been less evident is that the bill once again favors the well to do because the government’s largest subsidies—in the form of interest deductions—go to homeowners with the biggest and most expensive properties.

For many people without property, the new law may mean they will no longer make purchases that require borrowing. It can be argued that people can do without dishwashers, VCRs, or new cars. But it will be a serious loss when the children of a working couple decide they cannot go to college because expenses, both during their time as students and thereafter—in the form of loan repayments totaling hundreds of dollars a month—are too high. Many will have to forego “elective” medical expenses—everything from psychiatric help to orthodontics—because of the reduced sum of medical bills that are deductible and the inability to write off borrowing costs.

Those without property will also have fewer opportunities to try to start a business. Shelters have been a way to attract venture capital to new businesses since investors, without direct participation, could write off the losses usually accrued at the onset of a business. For example, under the old rules, a man in California could lend his brother in New York $100,000 to open a pizza parlor. The brother in California could then write off the initial losses on the business in New York until the other brother could make the pizza parlor profitable. It will be more difficult to set up such an arrangement after 1986 because the investor won’t have immediate use of his loss, and direct management participation is required to take business loss deductions. Someone starting out will either have to have sufficient capital himself or be able to show an immediate profit to an investor, an unlikely event in any business requiring some initial investment. This will certainly stifle business activity and, in effect, close off access to the American Dream.

A closer look at tax reform shows that it supports not the idea of the land of opportunity but instead something like a “landed gentry.” Those who start with some ingenuity, some enterprising energy, will have a much harder time establishing themselves in business. Quality education, which traditionally has been the way to rise in this country, will become increasingly inaccessible to all but the very rich. In the meantime, those who have the capital and own the property will consolidate their wealth, and opportunities for the have-nots will dwindle. The result in the end will be the further polarization of society, a widening gap between the rich, on the one hand, and, on the other, the middle class and the poor, and therefore less interplay between people from diverse socioeconomic and ethnic backgrounds. This goes to the very heart of the nation’s vitality; without it the country will have an increasingly small inbred elite. The new tax law does not bode well for either the health of the country or its people.

(I would like to acknowledge the assistance of Sheldon S. Cohen, Commissioner of the Internal Revenue Service between January 1965 and January 1969, now a partner in the law firm of Morgan, Lewis, and Bockius in Washington, DC, and Michael Schlesinger, partner in Schlesinger and Sussman, New York City.)

This Issue

February 12, 1987