NONCORPORATE BUSINESS TAXATION: 

BEFORE AND AFTER 

THE TAX REFORM ACT OF 1986 

Susan C. Nelson* 

U.S. Treasury Department 

OTA Paper 59 May 1988 

OTA Papers and Briefs are circulated so that the preliminary findings of tax 

research conducted by staff members and others associated with the Office of 

Tax Analysis may reach a wider audience. The views expressed are those of the 

authors, and,do not reflect Treasury policy. Comments are invited. but OTA 

Papers and'Briefs should not be quoted without permission from the authors. 

Additional copies of this publication may be purchased from the National 

Technical Information Service. 5285 Port Royal Rd., Springfield. VA 22 161. 

Phone: (703) 487-4660. 

Office of Tax Analysis 

U.S.Treasury Department, Room 4040 

Washington, D.C. 20220 

* The author is grateful to Jim Cilke for his help in running the OTA 

Individual Income Tax Model: to Joe Cordes, Tom Neubig, Eugene Steuerle, 

and participants in OTA's Work in Progress seminar for comments on earlier 

drafts of this paper: and to Pat Greene for preparing the manuscript. The 

views presented in this paper are those of the author and do not 

necessarily reflect those of the Treasury Department. 
CONTENTS 

PAGE 

I. Introduction 

11. Noncorporate Business Before the 

Tax Reform Act of 1986 

A. Trends in NIPA Income 

B. Trends in Income for Tax Purposes 

C. Partnership Income by Type of Partner 

D.Master Limited Partnerships 

111. Noncorporate Business After the 

Tax Reform Act of 1986 

A. Revenue 

B. Incentives 

C. Marginal Rates 

IV. Conclusion 

Footnotes 

References 

LIST OF TABLES 

Table 1: Income from Business and Capital in the 

Private Sector as a Percentage of Net 

National Product, Selected Years, 1950-1986 

Table 2: Net Income and Loss as Reported on Business 

Tax Returns. by Type of Return, 1970-1985 

Table 3: Income and Loss from Noncorporate Business 

Reported on Individual Income Tax Returns. 

1970-1985 

2 

2 

6 

13 

18 

20 

21 

23 

24 

27 

29 

30 

LO 

i 
Table 4:Income from Noncorporate Business 

Reported on Individual Returns as 

a Percentage of Income Reported on 

the Business Returns. 1970-1985 

Table 5: Partners’ Share of Gains and Loss, 

by Type of Partner and Industry, 1983 

Table 6: Average Financial Statistics for Master 

Limited Partnerships and All Limited 

Partnerships, 1985 

Table 7: Revenue Effects of Business Provisions 

of the Tax Reform Act of 1986, by 

Corporate and Individual Taxpayers 

(FY 1987 - 1991) 

PAGE 

12 

15 

19 

22 

Table 8: Marginal Tax Rates on Noncorporate Income 

of Individuals Before and After TRA, by 

Type of Business (1988 Levels of Income) 25 

LIST OF GRAPHS 

Graph I: Components of Business and Capital 

Income as a Percentage of Net National 

Product: Corporate vs . Noncorporate 

Income; 1950-1985 4 

Graph 2: Components of Business and Capital 

Income as a Percentage of Net National 

Product: Profits and Proprietors’ 

Income vs. Net Interest: 1950-1985 5 

Graph 3: Income Shares by Type of Partner, 1983 17 

.. 

11 
NONCORPORATE BUSINESS TAXATION: 

BEFORE AND AFTER THE TAX REFORM ACT OF 1986 

I. INTRODUCTION 

The Tax Reform Act of 1986 (TRA) marked a watershed in the history of 

taxation in this country. For the first time since the 16th Amendment 

permitted true income taxes, the top statutory tax rate on corporations 

will exceed the top rate on individuals. This fact, coupled with other 

changes in business taxation included in TRA, have prompted concerns that 

TRA's attempt to raise taxes on corporations relative to individuals may 

significantly increase the incentive for some business to shift into the 

noncorporate sector to avoid the corporation tax, resulting in an erosion of 

the corporate tax base. 

, Even before.TRA, questions were frequently raised whether business had been 

"disincorporating, " either shifting out of the corporate sector or starting in 

the noncorporate sector at a faster rate than in the corporate. The birth of 

master limited partnerships (MLP's) since the early 1980's was taken as one 

piece of evidence; the declining importance of the corporate income tax as 

another. 

The question of why revenues from corporate income taxes have been falling 1 

was recently addressed by Auerbach and Poterba. They demonstrate that 

corporate tax revenues have indeed fallen relative to GNP, corporate assets. 

and total Federal receipts since the early 1960's. They find that the 

explanation for this lies more in falling corporate profits than in 

legislative changes. They do not address the question of whether falling 

corporate profits have been accompanied by increasing profits or business 

income in the noncorporate sector. If that were true, then possibly, but not 

necessarily, the tax burden on all business and capital might not have fallen, 

even though less income was subject to the double tax on dividends. 

This paper examines trends in the noncorporate sector before TRA and 

analyzes some of the factors that will influence the future after TRA.* 

Section I1 addresses the pre-TRA experience, and Section 111 turns to TRA and 

beyond. 
-2-

Since taxes on income from noncorporate business are not separately 

reported on tax returns and therefore cannot be directly observed like 

corporate taxes, Section I1 focuses on measures of income used in the National 

Income and Product Accounts (NIPA) andincome reported for tax purposes in the 

corporate and noncorporate sectors in order to draw inferences about trends in 

the two sectors. Section I1 also looks at the growth in MLP’s and examines 

information from 1985 tax returns for the majority of MLP’s in existence then. 

In Section 111, the paper examines effects that the Tax Reform Act might have 

on noncorporate business in terms of revenue, relative incentives for 

corporate and noncorporate investment, and individual marginal tax rates on 

different types of income from noncorporate business. Section IV draws some 

tentative conclusions. 

11. NONCORPORATE BUSINESS BEFORE THE 

TAX REFORM ACT OF 1986 

A. Trends in NIPA Income 

Throughout the postwar years until the early 1980’s. income generated by 

business and capital in the private sector generally fell in relation to net 

national product (NNP). This was true of both the corporate and noncorporate 

sectors, although the decline was more erratic within the corporate sector. 

Table 1and Graphs 1and 2 show the percentages of NNP that came from various 

forms of business and capital income over the past four decades. From a high 

of 12.5 percent in 1950, the corporate share slipped to a low of 6.8 percent 

of NNP in 1982, with most of the drop occurring before 1970 (Graph 1). For 

the noncorporate sector as a whole and for the sector apart from ”Other 

Private Business” (which is dominated by net rent and interest on owneroccupied housing), the decline was more persistent but not as severe. Again. 

most of the decline took place before 1970. The noncorporate share of NNP 

registered 18.8 percent of NNP in 1950, 13.8 percent in 1970, and dropped to a 

low in 1982 (and 1983) of 13.3 percent. 

Underlying the trends for both sectors is a steady increase in the income 

paid out in interest, particularly since the mid- 1960’s, leaving corporate 

profits and proprietors’ income falling more sharply and persistently as a 

share of NNP (Graph 2). In 1950, corporate profits (with capital consumption 

and inventory valuation adjustments) accounted for 12.7 percent of NNP, for 

7.3 percent in 1970, but only 4.4 percent in 1982. In the noncorporate 

sector, proprietors’ income (with IVA and CCA) for sole proprietorships and 

partnerships was more than twice as large, relative to NNP. in 1950 as it was 

in 1982: 14.6 and 6.3 percent, respectively. A partial explanation for the 

rise in income going to interest might be that it reflects a rational. 

profit-motivated response to inflation for both corporate and noncorporate 
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3 borrowers. Net interest payments by the corporate sector, as well as by 

nonfinancial corporations alone, shot up between 1965 and 1970, and grew more 

slowly in the noncorporate sector. 

Since 1982 and the trough of the recession, most of these trends seem to 

have stopped and in some cases have even been reversed, although four years 

provide too little experience to be certain. As a fraction of NNP. total 

income in the corporate sector and corporate profits have not only recovered 

from the recession but have returned to their ranges of the 1970’s. While net 

interest in the corporate and noncorporate sectors is running higher than most 

of the 1970’s, it no longer appears to be rising, relative to NNP. 

Proprietors’ income from sole proprietorships and partnerships has been slower 

to bounce back from the recession, but it has been increasing steadily as a 

share of NNP. 

Do these trends provide evidence of disincorporation, or a shift of 

economic activity from the corporate to the noncorporate sector, in recent 

years? The answer is no. As row 13 (third from the bottom) of Table 1 shows. 

income from the corporate sector has hovered around 40 percent of total income 

from business and capital in the private sector throughout this period. While 

corporate income varies relative to noncorporate income from year to year 

(corporate income is more cyclical than noncorporate income), there does not 

appear to be any persistent trend over time. This conclusion holds as well if 

corporate income is compared to income from the sole proprietorships and 

partnerships (row 14), or if corporate profits are compared to proprietors‘ 

income from partnerships and sole proprietorships (row 15). Income from 

business and capital has been shrinking over the past four decades relative to 

NNP but no faster in the corporate than in the noncorporate sector. 

B. Trends in Income for Tax Purposes 

Although the national income accounts show no shift from corporate to 

noncorporate activity, there could have been a shift between the sectors for 

tax purposes. The fall in corporate taxes relative to total budget receipts 

or national income that Auerbach and Poterba addressed is well known and 

contributed to congressional willingness during tax reform to pay for 

reductions in taxes on individuals by raising taxes on corporations. Whether 

taxes on income from noncorporate business have also fallen over the past 

several decades is not apparent and cannot be determined directly since taxes 

on noncorporate business are reported in combination with other taxes paid by 

the owners. Indirect evidence on changes in taxes on noncorporate business 

may come from looking first at the income reported on business tax retums. 

and secondly at the income from noncorporate business reported on individual 

income tax returns. 

Table 2 presents income and losses reported on corporate and noncorporate 

tax returns for the past 15 years, and average annual rates of change in the 
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income. These income measures are the starting point for taxpayers in 

determining the tax base at the corporate and individual levels. They reflect 

many of the provisions of the tax law pertaining to income measurement such as 

the depreciation schedules and accounting procedures used for tax purposes. 

For partnerships and Subchapter S corporations, however, they misstate income 

by excluding items of income and expense that are subject to different 

limitations or elections at the level of the individual partner or 

hare holder.^ Capital gains and tax preferences such as intangible drilling 

costs are the largest omissions. 

The figures in Table 2 offer conflicting evidence on whether or not there 

has been a shift in income for tax purposes between the corporate and 

noncorporate sectors. Over the whole period from 1970 to 1985, growth in net 

income less deficit, and in net income alone, was as strong on corporate 

returns as on sole proprietor or partnership returns: net income less 

deficit grew at an average annual rate of 9.0 percent for corporate returns. 

but only 6.3 percent for sole proprietorships, and fell at a rate of 3.4 percent for partnerships. However. corporate income has been growing at a 

declining rate, while the noncorporate returns do not show such a trend. 

Within the noncorporate secior, losses consistently grew faster than net 

income on all types of returns. Subchapter S corporations in the 1980's 

provided the only exception to this. With the increase from 25 to 35 in the 

allowable number of shareholders and other simplifications of the Subchapter S 

rules in 1982. a rapid growth in Subchapter S income is consistent with the 

expectation of profitable corporations shifting away from double taxation of 

corporate dividends when given the chance. On partnership returns, the rate 

of growth of losses actually slowed between the early 1970's and the 198O's, 

in spite of the boom in tax shelters in the late 1970's and early 1980's. 

Sole proprietorships were the slowest growing type of noncorporate business. 

Net income and deficit both had lower growth rates on proprietorship returns 

than on Subchapter S or partnership returns. 

Since most noncorporate income is taxed at the individual level, income 

reported on individual returns is more directly related to the tax burden 

imposed on this form of income than is the income reported on the business 

return. Table 3 shows the net income, gains and losses from each type of 

noncorporate business as reported on individual income tax returns from 1970 

to 1985, and the average annual rates of change in those measures. At the 

individual level, net income less deficit and income from noncorporate 

business have been growing more slowly than AGI. If the income distribution 

of these forms of income has not changed appreciably, this suggests that the 

taxes paid on noncorporate business income might have fallen relative to total 

individual income taxes. 

Several interesting points emerge from comparing the noncorporate income 

and losses reported on individual returns and on the business returns 

(Table 4). First, a substantial amount of Subchapter S net income and deficit 

does not appear on the returns of individuals. Typically, individual returns 
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show only 60 to 70 percent of net income and 70 to 80 percent of the deficits, 

even though individuals are practically the only taxpayers allowed to own 

shares of Subchapter S corporations. Several factors might contribute to the 

”missing” gains and losses. (1) Some of the income goes to estates and 

trusts, which can also own Subchapter S stock. Based on data for 1982. the 

most recent available, estates and trusts might explain almost 40 percent of 

the $3.8 billion difference in Subchapter S net income less deficit reported 7 

on individual returns and on the corporate returns. (2) Some items of income 

and expense that are-separately treated at the shareholder level and are 

included in ordinary income of the owner are not included in income on the 

Subchapter S return, though these are probably small. (3) Gains on individual 

returns refer to the net amount on returns where gains exceed losses, whereas 

gains on the Subchapter S returns are the sum for corporations with net income 

(and similarly for losses). If this were the cause of the difference, net 

income less deficit would be (approximately) the same for individuals as for 

Subchapter S returns, but they are not. Furthermore, data in years when both 

total and net gains (and losses) have been reported still indicate a 

substantial, though smaller, amount of ”missing” gains and losses. (4)Some 

income might go to nontaxable individuals, but this too is likely to be small. 

(5) Another possible explanation is simple underreporting at the individual 

level, but individuals have no incentive to avoid reporting losses. 

A second difference between income reported on the business and individual 

returns applies to partnerships. Not only does less than 100 percent of the 

income and loss from partnership returns appear on individual returns. the 

fractions of income and net income less deficit have been generally decreasing 

since 1970, according to Table 4. In 1970, 88 percent of partnership net 

income was reported on individual returns, but only 45 percent in L985. For 

the years when data are available, the decline in the ratio of total 

partnership income at the individual level to gains reported on partnership 

returns is just as pronounced as the ratio using net partnership income of 

individuals. This suggests that a shrinking fraction of partnership income is 

being taxed at the individual level. Where the other income has gone is 

unclear. There might be increased underreporting, or increased importance of 

separately treated items. A further and likely possibility is that partners 

other than individuals have come to receive an increasing share of partnership 

income and losses. 

C. Partnership Income by Type of Partner 

Unfortunately, few data are available on the distribution of 

partnership-level income and losses among different types of partners, and no 

data exist on changes over time. The Statistics of Income Division of the 

Internal Revenue Service conducted a study of the Schedules K and K-1’s 

8 accompanying 1983 partnership returns. This study suggests that income and 

loss going to partners other than individuals explains much of the difference 
- 14-

between partnership income appearing on individual returns and on partnership 

returns. The study has several drawbacks that limit the reliability and 

universality of its results, however. The primary limitation is that the 

study was based only on partnership returns with 50 or fewer partners because 

the task of manually coding every K-1 for larger partnerships would have been 

enormous. In addition, information on the K-1’s of about 10 percent of the 

returns with 50 or fewer partners was inconsistent with information on the 

Schedule K, and the partnership had to be excluded from the study. In the 

end, the sample of returns studied represented over half of the partners and 

nearly 90 percent of the partnerships. Although it must be used with some 

caution, SOI’s K/K-1 study offers the only source of information on the 

distribution of partnership income among partners. 

Table 5 (and Graph 3) summarizedatafrom the K/K-1study on the income and 

9 losses going to different types of partners. Partnerships are classified by 

net income or loss and by industry. The table indicates that in 1983. 

individuals received 62 percent of the unadjusted partnership gains in firms 

with 50 or fewer partners, and 54 percent of the unadjusted partnership losses 

in those firms. These figures are generally consistent with the percentages 

that partnership gains and losses on individual returns represent of the gains 

and losses reported on partnership returns in 1983. (Data from the 1983 

individual and partnership Statistics of Income show that total partnership 

gains (without netting of losses) on individual returns represent 60 percent 

of total gains reported on partnership returns, while the comparable figure 

for losses is 61 percent.) 

This consistency suggests that at least in 1983 much of‘the difference 

between the gains and losses shown on partnership returns and the partnership 

income reported on individual returns probably can be explained by income 

going to other partners, rather than by underreporting or separately treated 

items of income and expense that would only appear at the individual level. 

Whether income going to other partners has increased over time and can explain 

the decreasing share of partnership income that appears on individual returns 

cannot be determined from one year’s data. 

The importance of other types of partners varies considerably among 

industries, and to some extent between gain and loss partnerships. Overall 

(among partnerships with 50 or fewer partners), corporations received 

22.5 percent of income from gain partnerships and 26 percent of losses from 

loss partnerships in 1983. This ranges from a high of over 70 percent of 

income in the transportation, communication, electric. etc. industry, to about 

40 percent of income from mining, to a low of less than 10 percent of gains 

and losses in agriculture. The role of partnerships as partners also varies 

substantially. Partnerships appear most prominently in mining, where they 

received 22 percent of the unadjusted gains and 18 percent of the losses. and 

in real estate, where they accounted for 12 percent of gains and 19 percent of 

losses. Except in mining, they received larger shares of losses than of 
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Graph 3 

INCOME SHARES BY TYPE 

OF PARTNER, 1983 

Shares of Gains Gain Partnerships 

0.8 

0.7 

0.6 

0.5 

0.4 

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0.1 

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Ail Transp. Industries Agripulture Mining Comm., etc. Real Estate Selvices 

Shares of Losses Loss Partnershi 

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n 

Industries Ai' Agriculture Mining Transpetc. Real Estate Services 

Type of Partner 

Corporations 

aIndividuals 

Partnerships 

74 Fiduciaries 

Kl "Other" 

Unknown 

NOTE: Shares apply to partners in partnerships with fewer than 50 partners in 

Sourcce: Table 5. 
-I 8-

gains. Fiduciaries and "other" types of partners (which includes tax-exempt 

institutions, cooperatives, nominees) received small shares of partnership 

income, and typically more of the gains than of the losses. 

D, Master Limited Partnerships 

Large partnerships whoseshares are traded on organized exchanges, commonly 

referred to as master limited partnerships (MLP's), have one foot in both the 

corporate and noncorporate sectors. Structured and taxed like partnerships, 

with all income and expenses flowing through to the partners. to many 

observers they have the characteristics of corporations: free transferability 

of interests, continuity of life, and centralization of management. Since the 

first MLP was organized in 1982, they have grown rapidly until they number 

well over 100 now. Through 1985, MLP's were confined to the oil and gas. real 

estate, and timber industries. Since that time, they have been appearing in a 

wide range of industries, including restaurants, professional sports teams, 

and movies. 

This growth in numbers and expansion in activities generated concern at the 

Treasury Department and in Congress that continuedrapid growth of MLP's could 

seriously erode the corporate tax base. and led Congress in 1987 to enact 

several provisions that would restrain future growth in MLP's and other 

"publicly traded" partnerships. Specifically, the 1987 legislation woirld tax 

as a corporation essentially any newly formed MLP unless it operated in the 

real estate or natural resource industries. or received the bulk of its income 

1 0 from other "passive-type" activities. All MLP's existing when the 

legislation was enacted would continue to be taxed as partnerships until 1998. 

In addition, the legislation declares that net income from MLP's and the other 

publicly traded partnerships, with no "grandfathering," is deemed to be 

portfolio income for the purposes of passive loss limitations, and therefore 

cannot offset tax shelter losses. 

Table 6 documents some of the major differences between MLP's and limited 

partnerships in general in 1985. Based on tax returns for nearly threequarters of the MLP's in existence in 1985 and on SO1 data on limited 

partnerships, Table 6 presents average financial statistics for limited 

partnerships and for MLP's, categorized by industry and gain or loss in 

ordinary income. The most striking difference, of course. is that the average 

MLP. with over 8,000 partners and $300 million in assets, is much larger than 

the average limited partnership with only 28 partners and $2.3 million in 

assets (Columns 2 and 5). The gain or loss in ordinary income is also much 

larger for MLP's, averaging $21 million in gain and $5 million in loss. 

compared to an average of $200,000 in gain and $300.000 in loss for all 

limited partnerships. While MLP's also showed larger amounts of 

debt--$38 million on average, compared to $2 million on average for all 

limited partnerships (Column 6)--MLP's had much smaller debt/equity ratios 

(Column 7). The 1985 ratio of debt to partners' capital accounts for MLP's of 
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-20-

.144 was well below the average of 7.819 for all limited partnerships (and 

even below the .738 ratio for nonfinancial corporations that year). This 

ratio is lowered somewhat by equity-only MLP’s that receive virtually all 

their income from other partnerships, which incur some debt, Even when these 

MLP’s are excluded, the debt/equity ratio remains well below .5. 

The MLP tax return data also illustrate the point made earlier in this 

paper that ordinary income is frequently not a good measure of the income from 

a partnership that is reported on partners’ tax returns because it omits 

important flow-through items. From examining actual MLP returns, it was 

possible to calculate the income that actually went to the partners. Column 4 

shows that ”Income to Partners, I’ ordinary income adjusted for separately 

stated items, was substantially less than the Form 1065 ordinary income for 

MLP’s in the oil and gas industry. because of intangible drilling costs and 

depletion allowances. Seventeen MLP’s in oil and gas had positive ordinary 

income but only nine had positive income to partners. (Several of the oil and 

gas MLP’s were registered as tax shelters.) In real estate and timber, income 

to partners exceeded ordinary income because of capital gains. Three MLP’s 

had losses in ordinary income, but only one had negative income to partners. 

111. NONCORPORATE BUSINESS AFTER THE 

TAX REFORM ACT OF 1986 

The Tax Reform Act raised taxes on business by expanding the definition of 

income subject to tax and eliminating or reducing tax credits for certain 

activities. At the same time it lowered taxes by reducing the corporate and 

individual tax rates applied to most of that income. 

In general, provisions of TRA that changed the definition of business 

income subject to tax and that altered tax credits available to business made 

no distinction between corporate and noncorporate activities, though some 

changes of course had more impact on one sector than the other. Major 

examples of base broadening that applied across the board are the 

modifications to the accelerated cost recovery system, elimination of the 

investment tax credit, reduced deductions for business meals and entertainment 

expenses, uniform cost capitalization rules, and repeal of bad debt reserves. 

One base-broadener applicable only to pass-through entities and similar firms 

that are subject to the corporate income tax (personal service corporations) 

is the requirement that the fiscal years of thesellentities correspond to the 

taxable years of their major partners or owners. At the individual level. 

the passive loss limitations, changes in the minimum tax, and elimination of 

the 60 percent exclusion for long-term capital gains broadened the tax base of 

income from business and capital. 

The remainder of this section examines three major effects that these 

changes from TRA will have on business: (1) They will increase the taxes paid 

by corporate and noncorporate business. (2) They will alter the incentives to 
-21-

invest in the corporate relative to the noncorporate sector. (3) They will 

lower the marginal tax rates paid on income from noncorporate business. 

A. Revenue 

Table 7 shows the five-year revenue effects on corporations and individuals 

of the major provisions that broadened the base of business income taxes. 

Overall, changes in the measure of business income subject to tax and 

allowable tax credits will raise corporate taxes by $250 billion from FY 1987 

through 1991. (Some of these provisions, notably many of the changes in 

accounting and depreciation, reflect changes in the timing of tax liabilities 

more than in the long-term level of taxes, however.) A reduction in tax rates 

from a maximum of 46 percent to 34 percent offsets $1 19 billion of the base 

broadening, for a net increase in corporate taxes of $131 billion. This 

amounts to a 29 percent increase compared to the five-year level of corporate 

taxes that would have been expected without TRA. 

For individuals, Table 7 shows a five-year tax increase from base 

broadening on business income of $68 billion. The benefit of individual rate 

reduction on this income is more difficult to calculate. Preliminary 

estimates from the Treasury Department’s Individual Income Tax Model suggest 

that reducing rates lowers taxes on incoy: from noncorporate business by about 

$25 to $30 billion over the five years. This amount offsets about 40 percent of the $68 billion tax increase from broadening the base. for a net tax 

increase of about $40 billion on individual income from noncorporate business. 

Compared to the taxes that would have been expected on this income in the 

absence of TRA, this represents a 60 percent increase. 

An alternative perspective on the tax changes for individuals might view 

the passive loss rules of TRA more as a tax increase on the income being 

sheltered (generally wage and salary income) than on income from noncorporate 

business. Taking this approach and excluding the tax shelter provisions from 

the Table 7’s estimate of base broadening would lower the 60 percent increase 

to a 15-20 percent increase in individual taxes on income from noncorporate 

business, lower than the 29 percent increase calculated earlier for 

corporations. 

Several qualifications need to be kept in mind in interpreting the estimate 

of the effect of rate reduction on income from noncorporate business. First. 

in this amount the rate cuts are ”stacked first.” that is, calculated before 

any other changes from TRA have been made. Stacking the rate cuts first is 

the way that Treasury and the Joint Committee on Taxation usually present the 

effects of separate tax reform provisions. Stacking the rate cuts first also 

means that the estimates do not include changes in incomes that would come in 

response to TRA provisions, and thus may understate the amount of rate 

reduction. Second. these estimates of the effect of rate cuts do not include 

the effect of eliminating the capital gains exclusion since many of these 

gains are from sales of corporate shares and other noncorporate business 
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sales. Treasury estimates this as raising $31 billion in revenue from 

FY 1987-91, with most of that coming in FY 1987 due to accelerated 

realizations before the exclusion was ended. 

B. Incentives 

TRA will affect the growth of the noncorporate sector by altering the 

relative attractiveness of investment in corporate and noncorporate business. 

The difference in total effective tax rates on income in the two sectors is an 

imporant indication of the incentive to invest in one sector over the other. 

Economists disagree. however, on how to measure these tax rates, and the 

answer to whether TRA made noncorporate investment more or less attractive 

than it was before, relative to corporate investment. depends on the approach 

selected.’ Three factors that particularly influence the comparison of 

effective tax rates are (1) the ratio of debt to equity in the financing of 

the investment, (2) the ”view” of dividends chosen. and (3) the asset mix used 

in the calculations. 

1. Debt/Equity. For equity-financed investments, the disadvantage of the 

corporate sector caused by the double taxation of dividends is well known. By 

lowering both corporate and individual tax rates. TRA tended to reduce this 

disadvantage. 

For debt-financed investments, interest deductibility means that such 

investments face only one level of tax in both sectors. The higher statutory 

tax rate in the corporate sector means that the value of tax depreciation 

allowances are larger for a corporation than a noncorporate firm. 

Consequently, debt-financed investment in depreciable property is tax favored 

in the corporate sector relative to the noncorporate sector. By lowering tax 

rates overall and reducing differentials among tax rates on alternative 

investments, the Tax Reform Act reduced the advantage of the corporate sector 

for debt-financed investment. 

2. The ”View” of Dividends. To the extent that corporate investment is 

financed with equity. the return would come to the stockholder as either 

dividends or capital gains. The ”old view” of dividends taxation says that 

taxes on both dividends and capital gains affect the after-tax return on 

equity. The ”new view” implies that taxes on dividends have been capitalized 

in the value of the equity and therefore do not burden the return to new 

equity. The capital gains tax is then the relevant tax on equity-financed 

investment. Since TRA raised capital gains taxes but lowered taxes on 

dividends, corporate taxes would tend to increase more under the new than the 

old view of dividends taxation. 

3. Asset Mix. The types of assets making up the capital stock and 

investment in the corporate sector differ from the noncorporate sector. In 
-24-

particular, a larger fraction of corporate than noncorporate investment is in 

equipment, which was the type of investment on which TRA raised taxes the 

most. Consequently, estimates of the effective tax rates for the corporate 

and noncorporate sectors as a whole would tend to show larger increases in the 

corporate rate, whereas asset by asset the differences would be smaller. 

Whether changes in effective taxes should be compared asset by asset or over 

all capital in the sector depends in part on the question being asked. The 

asset by asset approach is useful for determining how TRA changed the 

attractiveness of the two sectors for a given investment. Comparing changes 

in overall rates might suggest how the growth in overall investment will shift 

between the sectors. Since investment in equipment will become less 

attractive relative to other types of investment, TRA may tend to shift total 

investment out of the corporate sector and into noncorporate business. 

Fullerton, Gillette, and Mackie (FGM) estimate the effects of these various 

1 4 factors. Like most economists, they find that, before TRA. effective tax 

rates on income from corporate investments generally exceeded taxes on 

noncorporate income, except for fully debt-financed projects. FGM also 

conclude that TRA consistently raised effective tax rates in both the 

corporate and noncorporate sectors for investment in equipment and structures, 

and frequently lowered it for inventories and land. With TRA, the tax 

advantage to the corporate sector for fully debt-financed investments persists 

but is substantially reduced. overall and on an asset-by-asset basis. For 

investments that are financed by equity, in whole or in part, the overall tax 

advantage remains with the noncorporate sector but rises or falls slightly 

depending on the assumptions. On an asset-by-asset basis, however. TRA 

reduces the tax advantage of the noncorporate sector under most assumptions 

for equity investments. 

The FGM results generally support the conclusion that TRA "leveled the 

playing field" by narrowing differentials in effective tax rates between 

corporate and noncorporate sectors, given the type of financing. In addition. 

FGM's findings suggest that the Tax Reform Act may have reduced the 

attractiveness in many circumstances of setting up businesses as MLP's. which 

tend to be heavily financed by equity. instead of as corporations. 

C. Marginal Rates 

At the individual level, major changes in the taxation of income from 

noncorporate business resulted from Tax Reform's lower marginal tax rates for 

individuals and limitations on passive losses (including minimum tax treatment 

of allowed passive losses). Some implications of these changes can be drawn 

from examining effective individual marginal tax rates. before and after TRA. 

on income from noncorporate business. The top half of Table 8 presents. by 

type of business and by gain or loss, the average marginal rates that would 
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have prevailed in 1988 if pre-TRA law had continued, and the bottom half of 

the table presents marginal rates expected under TRA for that year. These 

rates were calculated using the Treasury Department’s Individual Income Tax 

Model. Taxpayers were classified as having gains or losses, and passive or 

active gains or losses, according to their net income from a particular type 

of business. 

The marginal rates in Table 8 reflect most of the provisions of pre- and 

post-TRA law that apply to individuals in 1988, including minimum tax and 

passive loss rules, but the rates estimated do not capture intertemporal 

effects of the provisions. For example, they do not include the value of tax 

credits for minimum taxes previously paid on allowed passive losses. They do 

not reflect the present value of currently disallowed (deferred) passive 

losses that will be allowed in the future, nor do they capture the fact that 

the real cost of most of the minimum tax provisions is a prepayment of taxes. 

Ideally, the marginal tax rates should include an estimate of the present 

value of these intertemporal aspects. In practice, taxpayers probably attach 

a large and varied degree of uncertainty to the value of future taxes or tax 

savings, making any choice of discount rate difficult. In addition, the 

available data were ill-suited for estimating the intertemporal components of 

the marginal rate. Consequently, the figures in Table 8 reflect changes in 

1988 taxes that taxpayers would see with a change in 1988 income or loss. 

The pre-TRA rates show several interesting characteristics of taxpayers 

receiving income from noncorporate businesses. The disparity in rates among 

taxpayers with different types of income indicates different amounts of total 

income: taxpayers with net losses had lower marginal rates than taxpayers with 

net gains from the same type of business, either because the losses were large 

enough to bring down their total income or because they had smaller amounts of 

other income. Partnerships are the category where the the marginal rates on 

gains and losses are closest (33.4 percent and 28.9 percent, respectively). 

which is consistent with a view that many partnership losses reflect tax 

. shelter losses incurred by taxpayers with substantial amounts of other income. 

The differences in marginal rates before and after TRA are striking. 

(1) On net and for retums with gains. each type of business received 

a reduction in marginal tax rates. Returns with Subchapter S gains showed the 

largest cut, from 43.6 percent to 27-28 percent. 

(2) The range of marginal tax rates on returns with gains of different 

types narrowed substantially, from a 15-point range to only a 5-point range. 

(3) The marginal rates on retums with passive losses from Subchapter 

S corporations or partnerships have dropped extremely low--5.5 percent and 9.0 

percent, respectively. 
-27-

The implications of the low marginal rates on passive losses are 

interesting. On one hand, the low rates indicate how little value passive 

losses have in the 1988 tax year. When the phase-in of the passive loss 

limitation is complete in 1991, passive losses will have even less currentyear tax value. On the other hand. these same low rates would be applied to 

additional passive income. If passive income became widely available to 

taxpayers with passive losses, the potential revenue loss could be 

substantial. On a dollar of partnership income in 1988, Table 8 indicates 

that more than half the tax revenue could be lost if it were deemed passive 

income and earned by a partner with passive losses, compared to the taxes it 

would generate if it went to any other average partner: 9 cents vs. 22 to 

25 cents. These marginal rates indicate the importance for protecting revenue 

of the Treasury regulations to distinguish passive income from portfolio 

income and the provision of the Omnibus Budget Reconciliation Act of 1987that 

characterized income from MLP's as portfolio income. 

An additional consequence of a broad definition of passive income would be 

an efficiency loss. If partners with gains or active losses facing a marginal 

rate of about 23 percent generally require an 8 percent pre-tax retum on an 

investment, taxpayers with passive partnership losses would require only a 

6.8 percent pre-tax return to achieve the same after-tax return. 

IV. CONCLUSION 

This paper has surveyed issues and data related to the taxation of 

noncorporate business before and after the Tax Reform Act of 1986. Before 

TRA, although income from business and capital appeared to be shrinking 

relative to the rest of the economy, this trend did not appear noticeably 

stronger in the corporate than in the noncorporate sector. In terms of income 

reported on tax returns, the rate of growth in corporate income was slowing 

but this was not true for noncorporate business. 

At the individual level, where most taxes on income from noncororate 

business are paid, there was evidence that taxes on income from noncorporate 

business. may have represented a declining share of total individual income 

taxes. In addition. a gap appeared to be growing between income of Subchapter 

S corporations and partnerships appearing on the business returns and on 

individual returns. Although the explanation is not clear. some of the 

missing Subchapter S income may flow to trusts and estates. while underreporting may also be involved. For partnerships, much of the apparent gap 

may reflect income going to partners other than individuals. Indeed. data for 

1983 indicate that corporations and other types of partners receive a 

co'nsiderable fraction of partnership income. particularly in the mining and 

transportation industries. 

After TRA. income from both corporate and noncorporate business will 

receive substantial tax increases in spite of reductions in marginal tax 
-28-

rates. Corporations will see a 29 percent increase over the taxes they would 

have paid if TRA had not been enacted. Individuals will pay 60 percent more 

on income from noncorporate business with TRA (or 15 percent more if the tax 

shelter provisions are excluded). Although taxes will be higher in both 

sectors, evidence available suggests that TRA narrowed the differentials in 

effective tax rates between the corporate and noncorporate sectors. and 

"leveled the playing field" on which investment decisions are made. At the 

individual level, taxpayers with income from noncorporate business 

consistently received cuts in the marginal tax rates on that income. The 

passive loss limitations so reduced marginal rates on passive losses that they 

will generate revenue and efficiency problems if passive income is easily 

available to offset passive losses. 
-29-

FOOTNOTES 

1Alan Auerbach and James Poterba, "Why Have Corporate Tax Revenues Declined?" in Tux Policy 

arid the Economy, Lawrence, H. Summers, ed. (NBER, 1987). 2 The term "noncorporate business" in this paper generally refers to sole proprietorships, 

partnerships, rental activities (at the individual level), and Subchapter S corporations. 

Although technically corporations, for tax purposes Subchapter S firms are more similar to 

partnerships than to corporations. 

1 

3 Inflation raises nominal interest rates, but interest payments are tax-deductible. 

Unanticipated inflation also erodes the value of debt. The combination makes debt-financing 

more attractive during periods of inflation than during price stability. 4 Partnership income adjusts ordinary income reported on partnership returns to remove income 

or losses from other partnerships (to eliminate double counting) and to add back payments to 

partners. This adjusted measure provides a better reflection of the aggregate income provided 

to the partners. 5For further discussion of the problems of determining partnership income that is potentially 

taxable, see Lowell Dworin, "An Analysis of Partnership Activity, 1981-1983," SO1 Bu//e/i/7, 

Spring 1986. The problems are similar for Subchapter S corporations. 6 Subchapter S corporations are shown separately, but they are also reflected in the 

cor7oration statistics. 

Income from Subchapter S corporations is not separately identified on returns filed by 

estates and trusts, but rather it is reported under "Other Income," along with any wages and 

salaries received by a decedent's estate, retirement account distributions that are counted as 

ordinary income, and certain refunds from overpayment of windfall profit taxes. Presumably, 

income from Subchapter S corporations account for the bulk of "Other Income." Data for 1982 

come from Gary Estep, "Fiduciary Income Tax Returns, 1982," SOZ Bulletiri, Spring 1985. 

8 Schedule K-l tells the individual partner his or her share of each partnership item, and 

Schedule K aggregates the K-1's overall partners. 9 Income and loss here are not adjusted as they are in Table 2 to remove the double counting 

of income from other partnerships nor to restore guaranteed payments to partners to partnership 

income. 

1 0See the testimony of Assistant Secretary of the Treasury J. Roger Mentz. before the 

Subcommittee on Select Revenue Measures. Committee on Ways and Means of the U.S. House of 

Representatives on June 30, 1987. Also, see pages 943-959 of the Conference Report accompanying 

the Omnibus Budget Reconciliation Act of 1987, House of Representatives, December 2 I. 1987. 

1 1The Omnibus Budget Reconciliation Act of 1987 allowed partnerships, S corporations. and 

personal service corporations to keep their fiscal years if they made "required payments" to 

offset the tax benefits deferral.

1 2This is lower than a $41 billion estimate made by Larry L. Dildine in "Effect on Industry." 

in Tux Reform aid the U.S. Economy, Joseph A. Pechman. ed. (The Brookings Institution: 1987). 

Much of the difference may be that Dildine applies the rate cuts to more sources of income than 

does the estimate presented here. For this estimate, noncorporate business income equals net 

income from sole proprietorships, partnerships. Subchapter S corporations. rents and royalties. 

and farms. 

l 3See more extensive discussions and analyses of the issues involved in calculating effective 

tax rates, see Don Fullerton, Robert Gillette, and James Mackie, "Investment Incentives Under 

the Tax Reform Act of 1986," in Comperzdium qf Tu Research, 1987. Office of Tax Analysis, U.S. 

Department of the Treasury (December 1987); and Alan Auerbach, "The Tax Reform Act of 1986 and 

the Cost of Capital," Joirmal of Ecorzomic Perspectives, Summer 1987. 

1 4 See Table 5. I1 of Fullerton et a/. 
-30-

REFERENCES 

Auerbach, Alan and James Poterba, "Why Have Corporate Tax Revenues Declined?" in 

Tar Policy and the Economy, Lawrence H. Summers, ed. (NBER, 1987). 

Auerbach, Alan, "The Tax Reform Act of 1986 and the Cost of Capital," Journal of 

Ecoiiomic Perspectives, Summer 1987. 

Dildine, Larry L., Effect on Industry," in Tar Reform and the U.S. Economy, Joseph A. 

Pechman, ed. (The Brookings Institution: 1987). 

Dworin, Lowell, "An Analysis of Partnership Activity, 198 1- 1983," SO/ Bulletin, 

Spring 1986. 

Estep. Gary, "Fiduciary Income Tax Returns. 1982." SO1 Bulleti/i, Spring 1985. 

Fullerton, Don, Robert Gillette, and James Mackie, "Investment Incentives Under 

the Tax Reform Act of 1986." in Comperidiiirn of Tux Research, 1987. Office of 

Tax Analysis, U.S. Department of the Treasury, December 1987. 

Mentz, J. Roger, Assistant Secretary. Testimony before the Subcommittee on 

Select Revenue Measures. Committee on Ways and Means of the U.S. House of 

Representatives. June 30, 1987.