Intramural Debates about the future of republican economic policy often take place between those who want to maintain the orthodoxy of small governments and those who blame free market fundamentalism for many of the country’s economic problems, from slow productivity growth to deindustrialization. But there is a political decision that both tax-cut supporters and reformist conservatives can join in order to remedy the situation: the Tax Reform Act of 1986 or TRA86.
This reform, which was passed in Congress with tremendous support from both parties, is often cited as a success of bipartisanism and a relic of a more functional Washington. Of course, the law contained some good reforms, like phasing out several tax protection strategies. However, the changes TRA86 made to the Corporate Income Tax Act increased taxes on investments in heavy industry and contributed to the decline in American manufacturing and slowing growth.
First, a connection. Corporate income tax is ideally a tax on corporate profits or revenues minus costs. In a perfect world, the capital cost of a factory would be deducted in the year it was built, as would labor costs. In reality, however, when calculating book income, the investment cost is spread over the life of the asset in order to balance the investment cost with the income generated.
While this may make sense for an accountant, it creates economic problems. Due to inflation and the time value of money, deductions for an investment five years from now will be less than deductions today, so businesses cannot deduct the true value of their investments as they would with labor or administrative expenses. This imbalance leads to a tax distortion in relation to capital-intensive sectors such as manufacturing.
The first series of “Reagan tax cuts,” the ERTA (Economic Recovery Tax Act) of 1981, expanded investment tax credits by introducing the accelerated cost recovery system. Under this system, companies could spread the cost of many types of equipment, machinery and structure investments over shorter periods of time and withdraw more of those costs sooner. These changes helped encourage capital investment, although aided by the concomitant decline in inflation.
The story goes on
Persistent problems with tax legislation, however, led to the demand for additional system reforms in the mid-1980s, which finally culminated in the adoption of the tax reform of 1986. The debate on whether to lower the corporate tax rate or keep ACRS was at the center of the debate. As Jeffery Birnbaum, author of Showdown at Gucci Gulch: Lawmakers, Lobbyists, and the Unlikely Success of Tax Reform, wrote on the 20th anniversary of the passage of the law, “light” industries like wholesalers preferred a lower rate while heavy industries preferred to hold accelerated depreciation . In the end, light industry won.
TRA86 lowered the corporate tax rate from 46 percent to 34 percent, but expanded the depreciation plans for various types of assets. The law extended the depreciation periods for numerous types of equipment, from industrial machinery to automobiles, airplanes and railroad parts, from five to seven years and removed the provisions that allowed companies to deduct a greater proportion of the cost in previous years. However, the biggest increase was in structures. Commercial structures (whether office buildings, warehouses or industrial centers) had to be deducted over 31.5 years instead of over 19 years. Residential structures also had to be deducted over 27.5 years instead of over the previous 19 years.
Norman Ture, an architect of the 1981 tax cut, called the 1986 reform the “Deindustrialization Act 1986” the year after it was passed. According to TRA86, investments in most asset classes fell short of expectations. And in 1993 the depreciation plans for commercial structures were increased to 39 years to make the breach worse. Since then there have been several temporary measures that have been used to grant so-called “bonus write-offs” to allow companies to withdraw some investments more quickly (usually equipment and machinery). The most recent example of this was included in the Tax Reduction and Employment Act 2017.
So far, most past empirical analyzes of these temporary reforms have shown that they have increased investment as well as productivity and wages. These changes should be made permanent. Regardless of where you stand on internal conservative policy debates, whether you’re looking to stimulate manufacturing or just cut taxes, setting depreciation by withdrawing capital investment immediately should suit your interests.