Tax Reform and the Cost of Capital

When the administration of President Ronald Reagan took office in January 1981, there was widespread concern about the slowdown of US economic growth. Tax reform proposals by the administration received overwhelming support from Congress with the enactment of the Economic Recovery Tax Act (ERTA) of 1981. The 1981 Tax Act combined substantial reductions in statutory tax rates for individuals and corporations with sizeable enhancements in investment incentives.¹

Beginning with the introduction of accelerated depreciation in 1954 and the investment tax credit in 1962, US tax policy had incorporated a series of progressively more elaborate tax preferences for specific forms of capital income. The Tax Act of 1981 brought this approach to its ultimate realization with adoption of the Accelerated Cost Recovery System (ACRS) and the introduction of a 10 per cent investment tax credit. With these provisions the 1981 Tax Act totally severed the connection between capital cost recovery for tax purposes and the economic concept of income.

The tax reforms of the early 1980s substantially reduced the burden of taxation on capital income. However, these policy changes also heightened the discrepancies among tax burdens born by different types of capital. These discrepancies gave rise to concerns in Congress about the impact of tax-induced distortions on the efficiency of capital allocation. In the State of the Union address in January 1984, President Reagan announced that he had requested a plan for further reform from the Department of the Treasury, setting off a lengthy debate that eventuated in the Tax Reform Act of 1986.²

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