Corporate Taxation and the Efficiency Gains of the 1986 Tax Reform Act

The 1986 Tax Reform Act, while having little effect on the overall effective tax rate on U.S. capital income, did reduce significantly the difference in effective taxation of corporate and noncorporate capital within a number of U.S. industries. The Mutual Production Model developed in Gravelle and Kotlikoff (1989) can be used to study the efficiency gains from the reduction in corporate tax wedges within industries. Unlike the Harberger Model, the Mutual Production Model permits both corporate and noncorporate firms to produce the same goods and, therefore, to coexist within a given industry. This paper develops an 11 industry - 55 year dynamic life cycle version of the Mutual Production Model. We use this model to study the steady state efficiency gains associated with the new law. While we do not simulate the economy's transition path, our steady state welfare changes are those that arise from compensating transitional generations for the first order redistribution of income associated with the Tax Reform. We find that the 1986 Tax Reform law reduces excess burden by .85 percent of our model's economy's present value of consumption. This efficiency gain reflects the Tax Reform's reduction in corporate non-corporate tax wedges, particularly in those industries with significant non-corporate production. Measured as a flow the 1988 estimated efficiency gain from the Tax Reform Act is $31 billion.