The Tax Reform Act of 1986 and Economic Growth

Abstract

Early tax reform proposals listed economic growth as a major goal, and some even gave explicit estimates of the expected increase in the long run output path that would follow from enactment. The 1986 Tax Act does not mention growth, much less give estimates of the expected increase, for good reason. The 1986 Tax Act will likely reduce the long-run output path by two to four percent. A revenue-neutral tax reform that raises the standard deduction and personal exemption cannot, in general, increase the bundle of goods one can purchase with an additional hour worked. Cuts in marginal personal tax rates can be achieved by broadening the tax base and shifting the tax burden to businesses. However, while the after-tax wage will increase, so will the after-tax cost of goods consumed, both currently and in the future, and thus work effort is unlikely to rise. Similarly, a tax reform that shifts the tax burden from labor and existing capital to new investments will likely lower saving and reallocate capital away from industrial uses. While the Tax Act will increase the efficiency of business investment, the potential efficiency gains are so small that actual gains will be swamped by the direct effect of a smaller business capital stock.