increasing the Code section 6661(a) penalty on underpayments of tax to 25 percent rather than 20 percent as provided in H.R. 3838 (sec. 1504). The conference report on H.R. 5300 was filed on October 17, 1986 (H. Rep. 99-1012), and was passed by the Senate and the House also on October 17. Although H.R. 5300 was signed before H.R. 3838, the H.R. 5300 provision was intended to prevail since it was considered and passed by the House and the Senate subsequent to passage of H.R. 3838.4 In addition, H.R. 5300 includes a provision (sec. 8071) relating to a truck leasing transitional rule included in the Senate amendment to H.R. 3838 (sec. 204(a)), application of at-risk rule to lowincome housing credit (sec. 8072 of H.R. 5300 and sec. 252(a) of H.R. 3838), and a transitional rule relating to treatment of certain rural housing under the passive loss rules (sec. 8073 of H.R. 5300 and sec. 502(d) of H.R. 3838). * See explanation in Title XV. Part. A., footnote 14. A technical correction may be needed so that the statute reflects this intent. Overview II. GENERAL REASONS FOR THE ACT The Tax Reform Act of 1986 (the "Act") represents one of the most comprehensive revisions of the Federal income tax system since its inception. Congress was concerned that many taxpayers found the prior-law tax system unfair and overly complex. Further, Congress believed that a number of features of the prior-law tax system resulted in excessive interference in labor, investment, and consumption decisions of taxpayers. After extensive review of virtually the entire prior tax statute, Congress concluded that only a thorough reform could assure a fairer, more efficient, and simpler tax system. Congress believed that the Act, establishing the Internal Revenue Code of 1986, will restore the trust of the American people in the income tax system and lead the nation's economy into greater productivity. The Act makes sweeping changes to the prior-law tax system. First, Congress desired a fairer tax system. Congress questioned the fairness of a tax system that allowed some high-income individuals to pay far lower rates of tax than other, less affluent individuals. The Act provides new limitations on the use of losses from passive investments to shelter other types of income and expands the minimum tax to curtail these tax inequities in the future. The Act also completely removes six million low-income individuals from the income tax roll and provides significant reductions in the tax burden of other working low-income individuals. Second, Congress desired a more efficient tax system. The priorlaw tax system intruded at nearly every level of decision-making by businesses and consumers. The sharp reductions in individual and corporate tax rates provided by the Act and the elimination of many tax preferences will directly remove or lessen tax considerations in labor, investment, and consumption decisions. The Act enables businesses to compete on a more equal basis, and business success will be determined more by serving the changing needs of a dynamic economy and less by relying on subsidies provided by the tax code. Third, Congress desired a simpler tax system for individuals. Beginning in 1988, the Act establishes two individual income tax rates-15 percent and 28 percent-to replace more than a dozen tax rates in each of the prior-law rate schedules, which extended up to 50 percent. Significant increases in the standard deduction and modifications to certain personal deductions provide further simplicity by greatly reducing the number of taxpayers who will itemize their deductions. Fairness A primary objective of Congress was to provide a tax system that ensures that individuals with similar incomes pay similar amounts of tax. The ability of some individuals to reduce their tax liability excessively under prior law eroded the tax base and required tax rates to be higher than otherwise would have been necessary. Congress was concerned that other individuals, unable to take advantage of tax shelters, had lost confidence in the tax system and may have responded by evading their tax liability. The Act provides a new restriction on the use of passive losses to offset unrelated income. Further, a strengthened minimum tax precludes higher income individuals from substantially eliminating income tax liability through the excessive use of preferences. With the adoption of these restrictions, the elimination of other preferences, and other base-broadening provisions, the Act sharply reduces the top individual tax rate from 50 percent to 28 percent, while leaving the tax burden of the highest income groups essentially unchanged. Congress believed that as a result of the sharp reductions in tax rates, it was no longer necessary to provide a lower tax rate for capital gains income of individuals. Eliminating the preferential treatment of capital gains income, and thereby eliminating the incentive to recharacterize certain income in order to qualify for capital gains treatment, is expected to eliminate the abuse of this provision and reduce the complexity of the tax system. The Act retains the most widely utilized itemized deductions, including deductions for home mortgage interest, State and local income taxes, real estate and personal property taxes, charitable contributions, casualty and theft losses, and medical expenses (above an increased floor). Other deductions that benefited a limited number of taxpayers, added complexity to tax filing, or were subject to abuse are restricted by the Act. For example, the Act tightens the requirements for deducting business meals and permits only 80 percent of business meal and entertainment expenses to be deducted. Other deductions available under prior law, such as deductions for attending investment seminars and for "educational" travel costs, have been eliminated. These expenditures differ little from other personal consumption expenditures, which generally are not deductible. As part of the approach of the Act to reduce tax rates through base-broadening, the Act disallows the itemized deductions for State and local sales taxes and phases out the deduction for personal interest expense for other than a mortgage on a first or second home. Congress also believed that these deductions provided tax benefits for consumption at the expense of savings and resulted in unnecessary complexity. Certain items of income that are similar to taxable compensation are no longer excluded from taxable income under the Act. For example, the prior-law partial exclusion for unemployment compensation is repealed, and most prizes and awards are includable in income. Also, the Act restricts the prior-law practice of some highincome families taking advantage of the graduated rate structure by transferring investment property to their minor children and thus sheltering their investment earnings at their children's lower tax rates. The Act makes numerous changes to increase employee eligibility for pension benefits. The Act expands the rules requiring coverage of a broad group of employees under an employer-maintained retirement plan, reduces from 10 years to five years the maximum time an employee must work for a given employer before becoming vested, and eliminates the ability of employers to offset completely the pension benefits of low-paid workers by the amount of their social security benefits. The Act also reduces the amount of income that can be deferred from taxation using qualified cash or deferred arrangements (sec. 401(k) and 403(b) plans), and provides tighter nondiscrimination tests to ensure that such plans do not disproportionately benefit highly compensated employees. Congress believed the prior-law tax treatment of individual retirement accounts (IRAs) was unnecessarily generous for individuals who participate in other tax-favored retirement arrangements, and the Act eliminates the deduction for contributions to an IRA for such individuals with income above specified levels. Congress believed that the lower tax rates provided by the Act will themselves stimulate additional work effort and saving, thereby eliminating the need for this deduction for these individuals. The Act permits these individuals, however, to make nondeductible contributions to an IRA and to defer taxes on the earnings of these contributions. To ensure universal availability of tax-favored retirement arrangements, the Act retains the prior-law IRA deduction for individuals unable to participate in other plans. In addition to ensuring that high-income taxpayers pay their share of the Federal tax burden, the Act provides tax relief to lowand middle-income wage earners. To achieve this goal, the Act substantially increases the standard deduction (the prior-law zero bracket amount) and almost doubles the personal exemption. Together with the greatly expanded earned income credit, these provisions relieve approximately six million low-income individuals from income tax liability and ensure that no families below the poverty level will have Federal income tax liability. The child care credit is preserved to assist working parents with their dependent care expenses. The elderly and blind also receive tax relief under the Act. Although such individuals will not receive an extra personal exemption as under prior law, an additional standard deduction amount of $600 is provided for married elderly or blind individuals and of $750 for single elderly or blind individuals. These extra standard deduction amounts are in addition to the increased standard deduction and personal exemption provided for all taxpayers. The priorlaw credit for certain elderly individuals and for individuals who are permanently and totally disabled is retained. Congress also believed that fairness in the tax system requires that corporate taxpayers pay amounts of tax appropriate for their level of earnings. Congress found it unjustifiable that under prior law some corporations reported large earnings and paid significant dividends to their shareholders, yet paid little or no taxes on that income to the government. Congress designed a strong alternative minimum tax for corporations, with a broad income tax base, to prevent corporations from significantly reducing or eliminating their tax liability. The Act makes changes to several accounting rules to provide more accurate matching between the recognition of income and deductions for expenditures related to this income. Large commercial banks will no longer be allowed to take deductions for bad debts before the underlying loan is determined to be wholly or partially worthless. Use of the installment method is restricted, and certain costs of inventory and self-constructed assets are required to be capitalized under the Act. Use of the completed contract method also is limited. Similarly, the Act reduces the deduction for unpaid losses of property and casualty insurance companies to account better for the timing difference beween the deduction and payment of losses. The Act modifies the tax treatment of foreign income. Congress desired to limit the incentives under prior law to move income offshore to avoid tax; accordingly, the Act restricts the ability of firms to use tax havens. The Act also limits the ability of taxpayers to use foreign taxes imposed on one kind of income to offset U.S. tax on unrelated income. The Act further provides for more accurate characterization of income as foreign source (and thus eligible for the foreign tax credit) or U.S. source (and thus ineligible for that credit). Certain provisions of prior law that benefited U.S. exporters paying high foreign taxes were retained, however, so as not to hinder the international competitiveness of U.S. firms. Together with other changes made by the Act, the aggregate corporate income tax liability is estimated to increase by approximately $120 billion over fiscal years 1987 through 1991, while the aggregate individual income tax liability is reduced by a similar amount. Even with these changes, the share of total income tax receipts paid by corporations will remain below pre-1980 levels. Congress also believed that it is important to maintain the trust of honest taxpayers in the tax system by ensuring that other taxpayers cannot illegally evade their tax liability. The Act extends information reporting requirements and provides for increased penalties for failure to report information properly to the Internal Revenue Service and for failure to pay tax. Efficiency The Act's most important measures in promoting the efficiency of the economy and in reducing the interference of the tax system in labor, investment, and consumption decisions are the dramatic reductions in personal and corporate tax rates. Lower marginal tax rates stimulate work effort and saving by leaving more of each additional dollar of wage and investment income in the hands of the taxpayer. Further, lower tax rates reduce the value of tax deductions, leading investment and consumption decisions to be made more on the basis of their economic merits and less on the value of tax benefits. The prior-law tax system contained a number of tax preferences that did not satisfactorily serve the purposes for which they were designed. In the past few years, tax incentives have contributed to the excessive construction of office buildings and record vacancy rates, excess investment in agriculture tax shelters by high-income |