In the conservative debate on tax policy, both sides should agree to repeal tax provisions that hurt manufacturers.
Intramural debates on the future of Republican economic policy are often framed as taking place between those who want to preserve small-government orthodoxy and those who blame free-market fundamentalism for many of the economic problems facing the country, from slow productivity growth to deindustrialization. But there’s one policy choice that both tax-cut devotees and reformist conservatives can join to remedy: the Tax Reform Act of 1986, or TRA86.
This reform — passed with enormous support from both parties in Congress — is often pointed to as a success of bipartisanship and a relic of a more functional Washington. To be sure, the law included some good reforms, such as shutting down several tax-shelter strategies. But the changes TRA86 made to the corporate-tax code ended up raising taxes on investment in heavy industry and contributing to the decline in American manufacturing and reducing growth.
First, some context. The corporate-income tax is ideally a tax on corporate profits, or revenues minus costs. In a perfect world, the cost of investment in a factory would be deducted in the year it is made, just like the cost of salaries. In reality, however, while calculating book income, investment costs are spread out over what is deemed to be the life of the asset, in order to match the cost of the investment with the revenue it generates.
While that might make sense for an accountant, it creates economic problems. Thanks to inflation and the time value of money, deductions for an investment five years from now are worth less than deductions today, so companies cannot deduct the real value of their investments as they do with labor or administrative costs. This imbalance creates a tax bias against capital-intensive industries such as manufacturing.
The first set of “Reagan tax cuts,” the 1981 Economic Recovery Tax Act (ERTA), expanded the investment-tax credit by implementing the accelerated cost-recovery system. Under this system, companies could spread the costs of numerous types of investment in equipment, machinery, and structures over shorter periods of time, and deduct a larger share of those costs sooner. These changes helped encourage capital investment, albeit aided by the concurrent decline in inflation.
However, persistent problems with the tax code led to the demand for additional systemic reform in the mid-1980s, which ultimately culminated in the passage of the 1986 tax reform. The debate over whether to lower the corporate-tax rate or maintain ACRS was central to 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 bill’s passage, “light” industries such as wholesalers preferred a lower rate, while the heavy industries preferred to keep accelerated depreciation. In the end, the light industries won.
TRA86 reduced the corporate-income-tax rate from 46 percent to 34 percent but extended the depreciation schedules for several types of assets. The act increased the depreciation periods for numerous types of equipment, from industrial machinery to cars, aircraft, and railway parts, from five years to seven years, and did away with the provisions allowing companies to deduct a larger share of the costs in earlier years. However, the biggest increase came for structures. Commercial structures (whether office buildings, warehouses, or industrial centers) had to be deducted over 31.5 years, instead of over 19. Similarly, residential structures had to be deducted over 27.5 years instead of the preceding 19.
Norman Ture, an architect of the 1981 tax cuts, referred to 1986 reform as “the Deindustrialization Act of 1986” the year after its passage. After TRA86, investment in most asset classes underperformed expectations. And in 1993, to add insult to injury, the depreciation schedules for commercial structures were increased to 39 years. Since then, there have been several temporary measures granting what’s called “bonus depreciation” to allow companies to deduct some investments faster (most usually equipment and machinery), the most recent example of which was included in 2017’s Tax Cuts and Jobs Act.
So far, most empirical analyses of these past temporary reforms have shown they increased investment, as well as productivity and wages. These changes should be made permanent. No matter where you stand on internal conservative policy debates, whether you want to stimulate manufacturing specifically or you just want to cut taxes, fixing depreciation by allowing capital investment to be deducted immediately should fit your interests.