Non-Neutral Taxation and the Efficiency Gains of the 1986 Tax Reform Act - - A New Look

The Tax Reform Act of 1986 considerably altered the differentials between taxes on corporate and noncorporate capital. Conventional wisdom, relying on various incarnations of the Harberger model, suggests rather small efficiency effects from these changes in corporate tax wedges. But the Harberger models appear to understate greatly the efficiency effects of changes in the corporate tax wedge because they do not admit production of the same good by both corporate and noncorporate firms. A new model which allows corporate and noncorporate firms to coexist within the same industry suggests a significant efficiency gain from the Tax Reform Act. The model predicts that the new law reduced excess burden by at least $31 billion and eliminated about half of the total distortion from non-neutral taxation. Most of this gain occurs because the Tax Reform Act, while keeping the aggregate effective tax rate constant, considerably narrowed these differentials in industries where there is substantial noncorporate production.