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Tax Reform Act of 1986

Tax Reform Act of 1986

Richard A. Westin

The Tax Reform Act of 1986 (P.L. 99-514, 100 Stat. 2085) implemented a tax code that at once swept away and reenacted its predecessor, the Internal Revenue Code of 1954. As a result, the tax code is now formally known as the Internal Revenue Code of 1986. Although the 1986 act reenacted the great bulk of the 1954 code, the fact that Congress renamed the Internal Revenue Code indicates the importance of the changes put in place by the 1986 act.

The new law did not affect the bedrock concepts of federal taxation. Before and after the Tax Reform Act of 1986, the income tax law relied on the concept of taxing only the income taxpayers realized during the taxable year (usually in the form of cash). The new law did not initiate radical variations of taxation, such as a sales or value-added tax base. Nor did the 1986 act have any meaningful impact on other components of the existing Internal Revenue Code, including:

  • Excise taxes, such as taxes on gasoline, cigarettes, and alcohol
  • Estate taxes, meaning taxes imposed on the taxable value of the estate of a dead person
  • Social Security taxes

The heart of the 1986 changes in the federal income tax act consist of the following six features:

  1. The act equalized the rate of taxation on long-term capital gains paid by individual taxpayers with the top rate of federal income taxation imposed on individuals. This was a dramatic change, because up to that point, capital gains enjoyed lower rates of taxation than did ordinary income from labor and investments, such as wages and dividends. Prior to 1986, these lower rates of taxation on capital gains led wealthy taxpayers to spend time and energy structuring their finances to maximize the portion of their incomes earned in the form of long-term capital gains. Consequently, the 1986 tax reform seemed to close a tax loophole . Later amendments to the Internal Revenue Code of 1986, however, reinstated the divergence in tax rates between capital gains and ordinary income this reform-minded element was eliminated, and the loophole continues to exist.
  2. The act decreased the use of tax shelters, devices taxpayers used to generate deductions and tax credits Congress accomplished this goal by enacting Section 469 of the Internal Revenue Code, known to tax experts as the "passive loss rules." The heart of the passive loss rules is that losses from passive tax shelters and losses from operating rental real estate can only be used as a deduction, or credit, against profits from other passive tax shelters and real estate. For example, a doctor could not deduct losses from real estate holdings against the income she earned in her medical practice. This largely put an end to taxpayers' use of tax shelters, which had, up until 1986, dramatically reduced federal revenues. Section 469 has a number of exceptions and limits, the most important of which are the following: (a) the rules do not apply to widely held corporations; and (b) passive losses are available in full only when a taxpayer disposes of the entire investment in a taxable sale or exchange. The new rules reportedly resulted in significant declines in the values of real estate.
  3. The act dropped the top rate of federal income taxation of individuals from 50 percent to 28 percent. After Congress reduced the tax rate to 28 percent, however, it increased the rate to almost 40 percent, but is on its way to reducing it again. The 28 percent rate applied equally to capital gains, discussed above, and all forms of other income. In addition, Congress reduced the top rate of taxation on corporations from 46 percent to 34 percent.
  4. The act eliminated deductions for interest expenses associated with buying personal consumption goods. (The sole exception is interest payments on home loans.) The prior law allowing interest expense deductions for borrowing money to buy consumer goods has always been questionable because it encouraged personal consumption. The repeal of the deduction eliminated this incentive. This part of the 1986 act has withstood the test of time and remains an important feature of American tax law.
  5. The act repealed the universal individual retirement account (IRA) deduction in favor of restricting the deduction to people who did not have pension coverage through other avenues, such as their employer. Before repeal, everyone, no matter how wealthy or how much they benefited from other pension arrangements, could take a deduction for contributions made to an IRA. Now, only certain taxpayers are permitted to do so. The universal IRA deduction was appropriately considered an unjustifiable source of revenue losses. The 1986 act is applauded for this change.
  6. The act eliminated federal income tax liability for those below the poverty line. This restored the laws as they existed in the late 1970s, when poor people were excluded from the obligation to pay taxes. This particular reform was made necessary by the effects of inflation: inflation increases people's nominal income and therefore their income taxes, even though in real economic terms they live in poverty.


The first inkling of the 1986 act appeared in 1984 in President Ronald Reagan's State of the Union address. Reagan announced that he was asking the secretary of the treasury to develop and present a comprehensive plan to simplify the tax code by the year 1984. Reagan was reacting to Republican concerns that Senator Walter Mondale, Democrat of Minnesota, might propose radical simplifications of the Internal Revenue Code and thus gain political popularitypopularity Reagan and his Republican Party hoped to enjoy. Reagan proposed that the new law be simple, fair, and broad-based. Specifically, it had to contain these features:

  • It had to be revenue-neutral, that is, neither adding to nor subtracting from federal revenues. Instead, the focus was on broadening the tax base and reducing rates.
  • It had to be distributionally neutral, that is, not favor one economic group over another.
  • It had to close major tax loopholes, such as the tax shelters described above. Reagan hoped that by closing loopholes, more taxes would be paid into the government, which would, in turn, allow an overall reduction in the tax rates (like the reduction in tax rates from 50 percent to 28 percent described above).

These proposals sat well with the powerful head of the House Ways and Means Committee, Representative Dan Rostenkowski of Illinois. Rostenkowski, a traditional populist Democrat, wanted to reduce the burden of taxation on working people and was capable of imposing his will on his committee. Without his cooperation, the proposals would have been doomed. On the opposite side of the aisle, Senator Robert Packwood, Republican of Oregon, played a less significant but nevertheless important role in working for passage of the act.

The act itself was capable of passage only because it had features that were attractive to both conservative and liberal politicians. To fiscal conservatives, dropping tax rates represented an opportunity to impose supply-side economics (a theory of economics that assumes lower taxes will generate more government revenue in the long run). Liberal tax theorists were attracted to broadening the tax base by closing loopholes, arguably taken advantage of by wealthy taxpayers and paid for by the poor through higher tax rates. Both conservatives and liberals believed the act promised higher levels of compliance by the taxpaying public.

Since passage of the Tax Reform Act of 1986, Congress has tinkered with the tax code almost every year, generally adding to the code's complexity and length.

See also: Corporate Income Tax Act of 1909; Federal Income Tax Act of 1913; Internal Revenue Act of 1954.


Birnbaum, Jeffrey, and Alan Murray. Showdown at Gucci Gulch: Lawmakers, Lobbyists and the Unlikely Triumph of Tax Reform. New York: Vintage Books, 1987.

Graetz, Michael. "Paint-by-Numbers Lawmaking." 95 Columbia Law Review 609 (1995).

Steuerle, C. Eugene. The Tax Decade. Washington, DC: Urban Institute Press, distributed by National Book Network, Lanham, MD, 1992.

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Tax Reform Act of 1986


The Tax Reform Act of 1986 (100 Stat. 2085, 26 U.S.C.A. §§ 47, 1042) made major changes in how income was taxed. The act either altered or eliminated many deductions, changed the tax rates, and eliminated several special calculations that had been permitted on the basis of marriage or fluctuating income. Though the act was the most massive overhaul of the tax system in decades, some of its key provisions were changed in the Revenue Reconciliation Act of 1993 (107 Stat. 416).

The 1986 act reduced the number of income tax rates to two rates of 15 percent and 28 percent for most taxpayers, although a third rate of 33 percent was imposed on income within a certain upper-middle income bracket. Congress and the administration of President ronald reagan believed a policy of low rates on a broad tax base would stimulate the economy and end an era of complex tax laws and regulations that mainly benefited those who knew how to manipulate the system.

The 1986 act also sought to eliminate special incentives that made tax shelters attractive and the tax law more complicated. Income derived from real estate became distinguishable on the basis of whether it was "active" or "passive." Passive income is income derived from a situation in which the taxpayer does not have an active management role, but it does not include capital gains on stocks, interest income on bonds, or interest on money market accounts. Before 1986 wealthy individuals could use passive income losses from a real estate tax shelter to offset active income. The 1986 act limited the deduction of passive losses to the amount of passive income but allowed taxpayers to carry forward any excess passive losses to the next year.

The act also eliminated the deductibility of nonmortgage consumer interest payments such as interest on credit card balances, automobile loans, and life insurance loans. It also established the floor for miscellaneous expenses at two percent of adjusted gross income for taxpayers who itemized deductions.

Individual Retirement Accounts (IRAs) once allowed a taxpayer to invest before-tax dollars and enjoy tax-free compounding of interest. The 1986 statute ended full deductibility of IRAs for single employees covered by qualified retirement plans and earning more than $35,000 annually. For married employees the cutoff for full deductibility was set at $50,000. In addition, the law imposed a penalty on withdrawals of IRA contributions before the age of fifty-nine and a half years.

Another retirement plan, the keogh plan, permitted under section 401(k), once allowed a taxpayer to invest up to $30,000 a year without paying taxes on this income. The ceiling dropped to $7,000 in 1987.

The act also eliminated a provision that had enabled two-income married couples to reduce their taxes. A couple can no longer take a deduction based on the lower salary of the two; the deduction had allowed them to pay the same tax on the lower salary as a single person would pay on that amount. The act also abolished "income averaging." Formerly, individuals whose incomes varied considerably from year to year could average their income over several years, a calculation that resulted in lower taxes owed in the years of highest income.

The ballooning federal budget deficits of the late 1980s and early 1990s led Congress to make changes in the 1986 act. The 1993 Revenue Reconciliation Act revamped the rate structure, imposing rates of 15, 28, 31, 36, and 39.6 percent. The act also limited itemized deductions for upper-income taxpayers and removed the limit on earned income subject to medicare tax. The 1993 act also established tax incentives for selected groups and reduced the amount that can be deducted for moving expenses and meals and entertainment.



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"Tax Reform Act of 1986." West's Encyclopedia of American Law. . 20 Oct. 2016 <>.

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