Twenty-four years ago, the broad tax revisions implemented by the Tax Reform Act of 1986 ( P.L. 99-514 ) were based on tax "neutrality"—the idea that economic efficiency and economic welfare are promoted if the distorting impact of taxes on business and other economic decisions is minimized. To this end, the 1986 act broadened the tax base for both businesses and individuals, scaling back various narrowly-applicable tax preferences and benefits, and reduced the statutory tax rate. In time, however, the general thrust of business-tax policy began to change, and in recent years policy has been guided more by a concern for the level of investment and capital formation, as well as the perceived impact of taxes on U.S. competitiveness. Thus, measures designed to promote tax-consistency across investments and activities have been supplanted by provisions designed to stimulate investment and assist in the ability of U.S. firms to compete with foreign companies. In contrast to 1986, however, much of the recent interest in reform has centered on a shift in the tax base to consumption rather than a comprehensive measure of income—a change in focus that is based, in part, on the same concerns for capital formation and competitiveness that underlie much of recent business-tax legislation. Twenty-four years after the 1986 act, business taxation is thus potentially at a crossroads. Another structural component of the system is the alternative minimum tax (AMT). Thus, to the conclusion that business taxes have generally declined in the post-World War II period, there is an additional important result: corporate investment remains relatively heavily taxed compared to non-corporate business and (especially) owner-occupied housing. Business Taxes and Capital Formation

Because they apply to the return on investment, business taxes can potentially reduce the economy's overall level of investment and its stock of capital. And while business taxes likely have little impact on long-run growth and capital formation, they do affect the allocation of investment among different uses and thus affect economic efficiency. This picture of the long-run burden of the corporate tax has implications for the vertical equity of the tax system—that is, its distribution across income classes. But the overall impact of the U.S. system is uncertain. Thus, if the validity of a separate corporate income tax is accepted, one hypothetical direction that tax reform might take is to move in the direction of a more pure version of the "classical" system of taxing corporate income—to eliminate the various omissions in the tax base and non-neutralities embedded in the current system. Corporate Tax Integration

As described above in the section on the economic effects of business taxation, the current "classical" system of taxing corporate income results in a number of distortions in the allocation of investment, thus reducing economic efficiency and causing a concomitant reduction in economic welfare. Business Taxes under Consumption or Flat Taxes

Either tax integration or a tax based on a comprehensive measure of income would qualify as fundamental tax reform. Their general effect on business taxes, however, would be the same: income from new business investment would be exempt from tax under each form.
A foundation of the broad tax revisions implemented 24 years ago by the Tax Reform Act of 1986 was tax "neutrality"—the idea that economic efficiency and economic welfare are promoted if the distorting impact of taxes on business and other economic decisions is minimized. Based on this principle, the 1986 act broadened the tax base and reduced statutory tax rates set forth by the tax code. In time, however, the underlying thrust of tax policy has changed. Rather than neutrality and efficiency, recent business tax legislation has been guided more by a concern for promoting investment and capital formation, and by attention to the perceived impact of taxes on the ability of U.S. firms to compete with foreign companies. Further, recent interest in fundamental tax reform has been partly stimulated by these same concerns for capital formation and competitiveness.
Twenty-four years after the 1986 act, business tax policy is thus potentially at a crossroads, and it is useful to take stock of where the system stands, the economic effects it is known to have, and the principal options for reform. Several data series show a similar pattern in the level of corporate taxes: corporate income taxes have generally declined over the post-World War II period. At the same time, however, significant disparities in the structure of business taxes have remained, suggesting a persistence of distortions caused by the tax system: corporate-sector investment remains heavily taxed compared to non-corporate business and owner-occupied housing; debt is favored over equity; and equipment is favored over structures.
The base of business taxation is the return to business investment; business taxes thus influence the economy through their impact on investment. In broad terms, business taxes can, at least in principle, reduce capital formation and thus impair long-term economic growth by making saving and investment less attractive. This effect, however, depends on a robust saving response to taxes, the presence of which is uncertain. Another impact is on the allocation of investment among different sectors and asset types. Here, business taxes likely distort investment decisions, reducing economic efficiency and economic welfare. In the case of equity, economic theory suggests that in the long run, the burden of business taxation is shared among all owners of capital and has a progressive effect on the tax system.
Various hypothetical alternatives exist for reforming the business tax system. One possibility is to move in the direction of the 1986 Tax Reform Act by broadening the existing tax base—that is, by eliminating tax benefits and preferences. Another possibility—and one that is favored by many economists—is to adopt some form of tax integration that would eliminate the double taxation of corporate income. A third option is to adopt a form of consumption tax, under which new business investment would be exempt from tax. Either corporate tax integration or a consumption tax could improve economic efficiency, but only if the design were to avoid the types of distortions present in the current system.
This report will be updated in the event of major changes in the business tax system.