The precipitous decline in tax sheltered investments after the Tax Reform Act of 1986 (TRA) is widely attributed to the passive loss rules. These rules disallowed losses from activities in which the taxpayer did not materially participate as a current deduction against all sources of income except for other passive activities. This paper demonstrates instead that the role of the passive loss limitations was secondary to that of other reforms enacted by TRA, most importantly the repeal of the investment tax credit and the long-term capital gain exclusion. These other reforms not only lowered after-tax rates of return on tax sheltered investments but also eliminated the positive correlation between the investor's marginal tax rate and the investment's after-tax rate of return. As a result, high income taxpayers ceased to be the natural clientele for legitimate tax shelters after TRA. The passive loss rules were more effective in curtailing the use of 'abusive' tax shelters; however, it is shown that a more narrowly focused restriction on seller financing of tax sheltered investments could have accomplished the same goal with much less scope for discouraging productive economic investments.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
5171.
Length: Date of creation: Jul 1995 Date of revision: Publication status: published relationship to a non-chapter. This should not happen. Please contact NBER. Handle: RePEc:nbr:nberwo:5171
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Find related papers by JEL classification: H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
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