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Tax Shelters and Passive Losses After the Tax Reform Act of 1986

  • Andrew A. Samwick

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.

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Date of creation: Jul 1995
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Publication status: published as Empirical Foundations of Household Taxation, Ed. by Feldstein and Poterba, University of Chicago Press, 1996, pp. 193-226.
Handle: RePEc:nbr:nberwo:5171
Note: PE
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  1. Feenberg, D.R. & Poterba, J.M., 1992. "Income Inequality and the Incomes of Very High Income Taxpayers: Evidence from Tax Returns," Working papers 92-16, Massachusetts Institute of Technology (MIT), Department of Economics.
  2. Gentry, William M., 1994. "Taxes, financial decisions and organizational form : Evidence from publicly traded partnerships," Journal of Public Economics, Elsevier, vol. 53(2), pages 223-244, February.
  3. Pechman, Joseph A, 1987. "Tax Reform: Theory and Practice," Journal of Economic Perspectives, American Economic Association, vol. 1(1), pages 11-28, Summer.
  4. Daniel Feenberg & Elisabeth Coutts, 1993. "An introduction to the TAXSIM model," Journal of Policy Analysis and Management, John Wiley & Sons, Ltd., vol. 12(1), pages 189-194.
  5. Harvey S. Rosen, 1987. "The Marriage Tax is Down But Not Out," NBER Working Papers 2231, National Bureau of Economic Research, Inc.
  6. Feldstein, Martin S & Taylor, Amy, 1976. "The Income Tax and Charitable Contributions," Econometrica, Econometric Society, vol. 44(6), pages 1201-22, November.
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