National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
TAX-PREFERRED ASSETS AND DEBT
TAX-PREFERRED ASSETS
AND DEBT, AND THE
TAX REFORM ACT
OF 1986: SOME
IMPLICATIONS FOR
FUNDAMENTAL TAX
REFORM
ERIC M. ENGEN
GALE **
*
& WILLIAM G.
Abstract - This paper focuses on two
aspects of the tax changes enacted in
the Tax Reform Act of 1986 (TRA86).
First, the TRA86 phased out tax deductions for interest on consumer debt,
which contributed to a marked shift in
the composition of household debt.
Second, the TRA86 restricted the tax
deductibility of contributions to
individual retirement accounts (IRAs)
for some higher-income households.
This appears to have contributed to,
but is not solely responsible for, the
shift in the composition of some
households’ portfolios of tax-preferred
saving incentive plans. This paper also
discusses the interaction of household
debt and 401(k) plans following the
TRA86. The aspects of the TRA86
focused upon in this paper appear to
represent examples of more typical
responses to tax changes: changes in
the composition of economic activity but
with little change in the real level of
economic activity. This conclusion is
consistent with the hierarchy of taxpayer responses suggested by Slemrod
(1990, 1995) and yields some potentially
relevant implications for fundamental
tax reform.
INTRODUCTION
The current debate on fundamental tax
reform is often described as merely a
choice between an income tax and a
consumption tax.1 This characterization
can easily lead to the general conclusion
that the effects of the Tax Reform Act of
1986 (TRA86) have little to offer in the
way of guidance concerning the effects
of a fundamental tax reform. The TRA86
enacted broad changes in the personal
and corporate income taxes by reducing
marginal tax rates and by broadening
the tax base via a reduction in tax
preferences, but did not embody a
fundamental shift from an incomebased tax toward a consumption tax.
*
Board of Governors of the Federal Reserve System,
Washington, D.C. 20551.
**
The Brookings Institution, Washington, D.C. 20036-2188.
331
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
While the shift to a consumption base is
an important part of fundamental tax
reform proposals, it may not be the only
relevant issue. For example, the flat tax,
which expenses investment at the
business level, is appropriately considered a consumption-based tax. If the flat
tax instead provided depreciation
allowances for investment, rather than
expensing, it would be an income-based
tax (Slemrod, 1995b). Our conjecture is
that, for a number of issues involved
with tax reform, a switch to a flat-taxwith-expensing might not lead to
dramatically different conclusions from
switching to a flat-tax-with-depreciation.2 If so, then at least for some
issues, the crucial point may not be the
distinction between an income tax base
and a consumption tax base, but rather
the desirability of broadening the
current hybrid income-consumption tax
base—whether the ultimate base is
consumption or income—and flattening
the current increasing tax rate structure.
The latter two issues, however, are
exactly the focus of the changes in the
TRA86, and potentially make the effects
of TRA86 relevant for understanding at
least some aspects of the debate on
fundamental tax reform.
out (eliminated) when adjusted gross
income exceeds $40,000 ($50,000) for
joint taxfilers and $25,000 ($35,000) for
single taxfilers. This appears to have
contributed to, but is not solely responsible for, the shift in the composition of
the portion of households’ asset
portfolios allocated to tax-preferred
saving incentive plans, such as IRAs and
401(k) plans. Before the TRA86, IRAs
constituted the majority of total saving
incentive contributions. However, IRA
contributions plummeted following the
restrictions imposed by the TRA86. By
1992, IRA contributions comprised less
than one-fifth of total saving incentive
contributions, while contributions to
401(k) plans grew to constitute about
three-quarters of total saving incentive
contributions.
Household debt and contributions to
tax-based saving incentives can also
interact in important ways. It is important to recall that household saving and
wealth are ultimately net concepts–
assets minus debt. Hence, studies
should also focus on how tax changes
affect household wealth, rather than
just assets or debt. However, these two
components of household wealth, and
the effects of tax changes on household
asset accumulation or household debt,
typically have been analyzed separately.
This paper discusses the interaction of
household debt and tax-preferred saving
following the TRA86.
In this paper, we focus on two aspects
of the tax changes enacted in the
TRA86 and discuss some of their effects
on households’ saving and debt
decisions. First, TRA86 phased out tax
deductions for interest on consumer
debt. This contributed to a marked shift
in the composition of household debt
away from consumer borrowing and
toward mortgages, the interest on
which remained tax deductible.
The aspects of the TRA86 focused upon
in this paper appear to represent
examples of more typical responses to
tax changes. They represent primarily
changes in the composition of economic
activity but with little change in the real
level of economic activity. This conclusion is consistent with the hierarchy of
taxpayer responses suggested by
Slemrod (1990, 1995a) and yields some
potentially relevant implications for
fundamental tax reform.
Second, TRA86 restricted the tax
deductibility of contributions to Individual Retirement Accounts (IRAs) for
higher-income households with a
retirement plan; deductibility is phased
332
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
TAX-PREFERRED ASSETS AND DEBT
The remainder of the paper is organized
as follows. The next section examines
trends in debt before and after the
TRA86. The subsequent section analyzes
interactions between IRAs and 401(k)
plans following the tax changes in the
TRA86. The following section examines
the interaction between households’
accumulation of debt and their accumulation of assets, particularly tax-preferred assets, in the period following the
TRA86. The final section concludes with
a discussion of some implications for the
design and implementation of fundamental tax reform.
in 1980 to 31.6 percent in 1986 to 42.8
percent by 1994. Consumer debt also
grew rapidly over much of this period,
rising at an annual rate of 10.3 percent
in the 1980s and 10.8 percent from
1980 to 1986.
The TRA86 phased out deductions for
consumer interest payments, but
retained the deduction for mortgage
interest for almost all taxpayers.4 This
reduced the price of borrowing through
mortgages relative to consumer debt.
From 1986 to 1994, consumer debt
outstanding grew at only 5.1 percent
per year, and fell from 21 percent of
disposable personal income in 1986 to
less than 19 percent in 1991 through
2
1993.
The composition of household
debt shifted toward mortgages during
the 1970s housing boom, was roughly
2
constant
from 1980 to 1986, and has
shifted further toward mortgages since
1986, even with flat housing prices.
TAX REFORM AND THE ALLOCATION OF
HOUSEHOLD DEBT
Since the early 1980s, the level of debt
held by U.S. households has risen
significantly. Data on aggregate trends
in household debt holdings compiled by
the Federal Reserve Board (1995) show
that nominal household debt, defined
as the sum of mortgage and consumer
debt, grew at an annual rate of 12
percent in the 1970s, 10 percent
between 1980 and 1986, and 8 percent
since 1986. This growth in debt
outpaced inflation, which (measured by
the CPI-U-X1) averaged 7.1 percent in
the 1970s, 4.9 percent between 1980
1 1986, and 3.8 percent from 1986
and
to 1994. Moreover, household debt has
undergone long-term growth relative to
disposable personal income or relative
1 household financial and housing
to
assets.
An increase in mortgage lending can
occur through increased home equity
lending, refinancing of first mortgages
that extract equity, and higher loan-tovalue ratios on new purchases of
homes. Manchester and Poterba (1989)
cite data showing that home equity
loans rose from 3.6 percent of outstanding mortgages in 1980 to 10.8 percent
in 1987. The U.S. General Accounting
Office (1993) cites different data with
similar ratios: 3.8 percent in 1981, 10.6
percent in 1986, and 12.2 percent in
1991. Most of the growth in home
equity lines of credit occurred after
1986: balances rose from $1 billion in
1981 to $32 billion in 1986 and $132
billion in 1991. Eugeni (1993) estimates
that outstanding home equity balances
rose from $268 billion in 1988 to about
$469 billion in 1992. Canner, Fergus,
and Luckett (1989) estimate outstanding home equity balances in 1988 of
between $210 and $265 billion.
Mortgage debt—defined by the
presence of a residence as collateral,
rather than by the use of the loan
proceeds—grew at annual rates of 12.7
percent in the 1970s, 9.7 percent
between 1980 and 1986, and 9.1
percent from 1986 to 1994. Relative to
the value of owner-occupied real estate,
mortgage debt rose from 27.5 percent
333
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
These different studies are roughly
consistent and suggest rapid growth of
home equity lending in the 1980s.5
Home equity lending can account for a
sizable portion of the increase in
mortgage debt before 1986, but a
smaller portion of the increase after
1986. Nonetheless, in the post-86
period, home equity lending may have
played an important role in enabling
households to change the composition
of their debt.
interest payments. They also find that a
dollar of reduced consumer interest is
associated with a 67 to 86 cents
increase in mortgage interest payments.
Using interest rate data from Canner,
Fergus, and Luckett (1988), these
3
estimates
suggest that a dollar in
reduced consumer debt raised mortgage
debt by between $0.87 and $1.11.6
Scholz (1994) uses cross sections from
the 1983 and 1989 Surveys of Consumer Finances. He finds that household
debt rose between 1983 and 1989.
Among higher-income homeowners,
property-backed debt rose rapidly.
Among low-income renters, who
presumably had less access to deductible borrowing after the TRA86, debt
holdings fell.
Mortgage refinancing represents an
alternative way to extract housing
equity. In a 1989 survey reported in
Canner and Luckett (1990), 20 percent
of households with mortgages had
refinanced their mortgage. Of those, 57
percent had extracted equity at the time
of refinancing. The mean and median
amounts extracted were $25,145 and
$15,941. These are roughly similar to
the mean and median for home equity
loans, $22,534 and $15,905.
Maki (1995) uses successive cross
sections of the Consumer Expenditure
Survey. He shows that high income
homeowners reduced their consumer
debt and raised their mortgage debt
after the TRA86, relative to other
households. He also shows that highincome renters did not reduce their
consumer debt holdings relative to other
renters and that households increased
their total debt.
Higher initial loan-to-value ratios (i.e.,
smaller down payments) are another
channel through which mortgage debt
can rise relative to the house value
backing the debt. Data from the Federal
Housing Finance Board (1995) shows
that aggregate loan-to-value ratios on
purchase money mortgages (i.e.,
primary mortgages that are not
refinancings) rose from 72.9 percent in
1980 to 77 percent in 1984, fell to 74.4
percent by 1991, and then rose to 79.9
percent in 1994. Similar time patterns
occur for the proportion of new loans
with loan-to-price ratios that exceed 90
percent.
Engen and Gale (1995) used successive
cross sections of the Survey of Income
and Program Participation (SIPP) in
1984, 1987, and 1991 to look at
household debt. Mortgage debt rose
across all income and age groups.
Median mortgage debt rose by 14
percent from 1984 to 1987 and by an
additional 37 percent from 1987 to
1991. Virtually all of this increase was
due to an increase in the ratio of
mortgage debt to house value, rather
than changes in house value.7 From
1987 to 1991, homeowners with family
earnings above $50,000 reduced their
holdings of consumer debt, while
Skinner and Feenberg (1990) use a
panel of taxpayers from 1984 through
1987 who itemize their tax deductions.
Their estimates imply that limiting the
deductibility of consumer interest in
TRA86 significantly reduced consumer
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National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
TAX-PREFERRED ASSETS AND DEBT
renters in the same earnings classes
raised their consumer debt holdings.
IRAs and 401(k) plans are unlikely to
be perfect substitutes. 401(k) plans are
tied to the work place, while IRAs are
not. 401(k)s usually have employer
matching of employee contributions,
while IRAs do not. 401(k)s and IRAs
generally have different contribution
limits, withdrawal and loan provisions,
and investment opportunities. 401(k)
contributions tend to be regular salary
reductions; IRAs can be funded anytime. For example, people may want
to put some money into a 401(k) but
then keep the flexibility of contributing
more to an IRA at a later date in the
tax year, depending on their income
and expenses. Nevertheless, IRAs and
401(k)s could very well be good
substitutes for some people (particularly
those who hold both 401(k)s and IRAs).
The plans represent alternative ways to
save for retirement, and 401(k)s should
be particularly attractive for high-income
households after the removal of tax deductibility for IRA contributions in 1986.
These studies have important implications for studying household saving
behavior and its response to tax
changes. First, these studies are consistent with the conclusion that the
composition of household debt portfolios is sensitive to the tax treatment of
different types of debt. Second, the
trends suggest the importance of
analyzing the effects of tax reforms on
broad measures of household wealth
which include liabilities as well as assets.
TAX REFORM AND THE ALLOCATION OF
TAX-PREFERRED SAVING
In this section, we examine the relationship between IRAs and 401(k) plans.
Since the early 1980s, tax-based saving
incentives plans, such as IRAs and
401(k) plans, gained tremendous
popularity.8 Total contributions to IRAs,
401(k)s, SEPs, and Keoghs increased
from less than 4 percent of personal
saving in 1981 to about 35 percent of
personal saving by 1985, and then
continued to comprise about one-third
of personal saving through 1992.
However, the restrictions imposed by
the TRA86 on deductible IRA contributions significantly changed the composition of saving incentive contributions.
Before the TRA86, IRAs constituted the
majority of total saving incentive
contributions. However, contributions
plummeted following the change in the
treatment of IRAs enacted in TRA86.
By 1992, IRA contributions comprised
less than 20 percent of total saving
incentive contributions. In contrast,
contributions to 401(k) plans grew
steadily since their tax treatment was
clarified in 1981 and constituted about
three-quarters of total saving incentive
contributions by 1992.
One way to test for substitutability is to
exploit the removal of tax deductibility
of IRA contributions for some higher
income families in the TRA86. If
households find IRAs and 401(k)s to be
substitutes, controlling for other factors,
the decline in IRA participation after
TRA86 should be larger for 401(k)
eligible households than for noneligible
households among income groups who
lost deductibility of IRA contributions.
Poterba, Venti, and Wise (1992) present
evidence related to this issue using data
from the Employee Benefits Supplement
of the 1988 Current Population Survey.
They find that for families with incomes
above $75,000, the IRA participation
rate dropped substantially more for
401(k) eligibles than for noneligibles. In
this group, the IRA participation rate
fell by 57 percentage points for eligibles
compared to 27 percentage points for
ineligibles.
335
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
Engen, Gale, and Scholz (1994) examined the relationship between IRAs and
401(k)s after TRA86, using data from
the SIPP. If 401(k)s and IRAs are substitutes, 401(k)-eligible families whose IRA
deductibility was restricted in 1986
should funnel more money into 401(k)
plans from 1987 to 1991 than eligible
families whose deductibility was not
removed, controlling for other factors
such as income and net worth. They
find that among 401(k)-eligible families,
not being allowed to make deductible
IRA contributions raised 401(k) balances
by $2,538 from 1987 to 1991. This
result is consistent with the hypothesis
that there is substitution between
401(k) plans and IRAs. Moreover, they
note that the average real 401(k)
balance among eligibles in the effected
group rose by about $4,300 between
1987 and 1991. Hence, the removal of
deductibility potentially can account for
half of the increase in 401(k) balances in
the higher-income group affected by the
removal of IRA tax deducibility in the
TRA86.
tion of wealth, where wealth is defined
as the sum of net financial assets
(financial assets minus consumer debt)
and housing equity (house value minus
morgage debt). Their analysis used data
from successive cross sections in 1987
and 1991 of the SIPP. They obtained
several results that point to important
interactions between household assets
and liabilities following the TRA86.9
Thus, there exists some evidence
implying that some households substituted away from IRAs into 401(k)s
following the TRA86. The TRA86
probably contributed to, but is almost
certainly not solely responsible for, the
shift in the composition of households
holdings of tax-preferred financial
assets. This is consistent with the conclusion that the composition of household asset portfolios is sensitive to the
tax treatment of different types of assets.
Second, they split the sample into
homeowners and renters. For renters,
being eligible for a 401(k) has no effect
on holdings of financial assets or net
financial assets. For homeowners,
401(k) eligibility raises gross financial
assets and net financial assets, but has
no effect on a broader measure of
wealth defined to include housing
equity. Third, similar results apply to the
effects of 401(k) participation in a set of
analogous tests that control for IRA
status and other factors.
First, between 1987 and 1991, controlling for IRA status and other factors,
households with at least one worker
eligible for a 401(k) plan did accumulate
more financial assets and net financial
assets than observationally equivalent
households that did not contain a
401(k)-eligible worker.10 But they also
show that 401(k)-eligible households
did not accumulate more wealth when
housing equity is included. House values
rose for eligibles relative to noneligibles,
but mortgage debt grew even faster, so
that housing equity fell for 401(k)eligible households relative to ineligible
households.
INTERACTIONS BETWEEN ASSETS AND
DEBT
The results imply that groups of families
that were eligible for 401(k)s or participated in 401(k)s and that had access to
mortgage debt, which was still tax
deductible after TRA86, raised their
financial assets and net financial assets
relative to other groups; but this
Engen and Gale (1995) examined
interactions between household assets
and liabilities by examining the effects
of eligibility for, and participation in,
401(k) plans on households’ accumula336
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
TAX-PREFERRED ASSETS AND DEBT
increase in one component of their
portfolio was fully offset by reductions
in housing equity, relative to the other
groups. 401(k)-eligible families, or
participants, that did not have access to
tax-preferred debt after the TRA86 did
not raise their financial or net financial
assets relative to other groups. In
summary, we find that no group of
families that was eligible for, or participated in, 401(k)s significantly raised its
wealth (including housing equity) from
1987 to 1991 relative to the
observationally equivalent group of
families that was not eligible or did not
participate. In showing that borrowing
and saving at the household level can
interact in important ways, these results
have direct implications for the effects
of tax changes on household portfolios
and saving.
mental tax reform. First, the anticipation
of tax reform may have important
effects on economic activity that serve
to offset some of the intended effects.
Virtually all analyses of fundamental tax
reform assume that the new system is
unanticipated and is imposed immediately. This eliminates the possibility of
timing responses in the economic
models being used, but does not
eliminate those responses in the real
world. Second, if a fundamental reform
from the current tax system to a consumption-based tax includes transitional
relief for existing capital, then this will
create differential tax treatment across
assets. The studies outlined above
suggest that these tax differences could
create large reshuffling of portfolios. A
case in point is the mortgage interest
deduction. If the deduction is removed,
then we expect households to substitute
out of mortgage debt, either by raising
their invest- ment debt (Maki, 1996) or
by paying down their loan with accumulated assets. If the mortgage deduction
is retained in a switch to a consumptionbased tax, then tax reform will have
created a conduit for tax-deductible
borrowing in a system that does not tax
interest income. Creating such arbitrage
possibilities could lead to large shifting
into mortgages.
DISCUSSION
Slemrod (1990, 1995a) has categorized
a hierarchy of taxpayer responses to tax
reform. The behavioral response most
sensitive to tax reform involves the
timing of economic transactions;
altering the timing of economic activity
in reponse to permanent variations in
the time pattern of tax rates or in
anticipation of future changes in the tax
law. The next most sensitive type of
taxpayer response involves avoidance
activities, including the reallocation of
asset and debt portfolios outlined
above. The smallest responses should be
expected in real economic behavior:
saving, labor supply, etc.11 The evidence
discussed in this paper is consistent with
this hierarchy. We note as well that,
typically, the timing and avoidance
effects are unintended consequences of
tax reform, while the real effects are
intended.
A final note of caution is warranted.
The top few percent of households, by
income or wealth, account for a very
large share of the net wealth accumulation in the United States. There is little
conclusive evidence on how such house
holds responded to the TRA86 (Slemrod,
1995a), but their impact on assets,
debt, and saving in any fundamental tax
reform proposal could prove decisive.
ENDNOTES
This suggests some implications for the
design and implementation of funda-
We thank Jane Gravelle for her comments on this
paper. All opinions are our own and should not be
337
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
1
2
3
4
5
6
7
8
9
ascribed to the staff, officers, or trustees of the
Federal Reserve Board or The Brookings Institution.
A third possibility is a wage tax. Because future
consumption may be financed only from existing
assets and future wage income, a consumption tax
that allows for transitional tax relief on consumption financed out of existing assets is essentially a
wage tax.
Note also that a consumption-based flat tax would
only exempt the portion of the overall return to
capital that reflects the opportunity cost of capital.
The portion of the return to capital that reflects
rents would be taxed in the same way under both
a consumption-based and an income-based flat tax
(Bradford, 1996).
See Engen and Gale (1995) for a more detailed
discussion of these trends in debt.
The phaseout of deductibility of consumer interest
occurred over five years. Deductibility was retained
on debt backed by a taxpayer’s first or second
residence, up to the taxpayer’s basis in the
property. The Omnibus Budget Reconciliation Act
of 1987 restricted deductibility of mortgage
interest to the first $1 million of acquisition debt
and the first $100,000 of home equity loans. Maki
(1995) provides further information.
Besides tax policy, the growth in home equity
lending has been attributed also to changes in
home values, changes in banking laws, and other
factors. See GAO (1993) and Canner, Fergus, and
Luckett (1988, 1989).
Canner, Fergus, and Luckett (1988) show average
rates in 1984 through 1987 of 11.6 percent for
home equity lines of credit, 18.4 percent for credit
card debt, 12.1 percent for new 48-month car
loans, and 15.3 percent for 24-month personal
loans. If the average rate on consumer debt (the
last three categories) is 15 percent, the estimates in
Skinner and Feenberg (1990) suggest that a dollar
reduction in consumer interest corresponds to a
$6.67 decline in consumer debt. At an 11.6
percent rate on home equity loans, a 67 (86) cent
increase in mortgage interest corresponds to an
increase of $5.78 ($7.41) in mortgage debt.
Hence, reducing consumer debt by a dollar would
raise mortgage debt by between 87 cents (5.78/
6.67) and $1.11 (7.41/6.67).
The median house value (1991 dollars) in the SIPP
was about $77,000 in 1984, $79,000 in 1987, and
$75,000 in 1991. These patterns are consistent
with data reported by Poterba (1991) on U.S.
housing prices. The mean ratio of mortgage to
house value in the SIPP rose 9 percent from 1984
to 1987 and 24 percent from 1987 to 1991.
See Engen, Gale, and Scholz (1994, 1996) for a
more detailed discussion of these trends in taxbased saving incentive plans.
See Engen, Gale, and Scholz (1996) also for more
discussion of the interaction between households’
contributions to tax-preferred 401(k) plans and
10
11
their accumulation of tax-preferred mortgage debt.
Poterba, Venti, and Wise (1995) obtained similar
findings for gross financial assets using similar data
from the SIPP.
Engen (1994) and Engen and Gale (1996) explicitly
analyze the potential real effects of fundamental
tax reform on household saving. These studies
conclude that switching to a consumption-based
tax would modestly increase household saving. In
assessing the effects of fundamental tax reform,
Engen and Gale (1996) note the importance of
realizing that in the current hybrid incomeconsumption tax, much of household saving is
already done through tax-preferred forms such as
pensions, saving incentive acounts, and owneroccupied housing. Sabelhaus (1996) documents
the importance of tax-preferred saving in aggregate household saving.
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Tax Reform Act of 1986.” In Do Taxes Matter?:
The Impact of the Tax Reform Act of 1986,
edited by Joel Slemrod, 1–12. Cambridge, MA:
MIT Press, 1990.
Manchester, Joyce M., and James M.
Poterba. “Second Mortgages and Household
Saving.” Regional Science and Urban Economics
19 No. 2 (May, 1989): 325–46.
Slemrod, Joel. “Income Creation or Income
Shifting? Behavioral Responses to the Tax
Reform Act of 1986.” American Economic
Review 85 No. 2 (May, 1995a): 175–80.
Poterba, James M. “House Price Dynamics:
The Role of Tax Policy and Demography.”
Brookings Papers on Economics Activity 2 (1991):
143–203.
Slemrod, Joel. “What Makes Some Consumption Taxes So Simple, and Others So Complicated?” Paper presented at the Conference on
Fundamental Tax Reform, sponsored by the
Center for Economic Policy Research at Stanford
University, Stanford, CA, 1995b.
Poterba, James M., Steven F. Venti, and
David A. Wise. “401(k) Plans and Tax-Deferred
Saving.” NBER Working Paper No. 4181.
Cambridge, MA: National Bureau of Economic
Research, 1992.
U.S. General Accounting Office.
Tax Policy:
Many Factors Contributed to the Growth in
Home Equity Financing in the 1980’s. GAO/
GGD-93-63, Washington, D.C., March, 1993.
Poterba, James M., Steven F. Venti, and
David A. Wise. “Do 401(k) Contributions
Crowd Out Other Personal Saving?” Journal of
Public Economics 58 (September, 1995): 1–32.
339
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Vol 49 no. 3 (September 1996) pp. 331-39
TAX-PREFERRED ASSETS AND DEBT
TAX-PREFERRED ASSETS
AND DEBT, AND THE
TAX REFORM ACT
OF 1986: SOME
IMPLICATIONS FOR
FUNDAMENTAL TAX
REFORM
ERIC M. ENGEN
GALE **
*
& WILLIAM G.
Abstract - This paper focuses on two
aspects of the tax changes enacted in
the Tax Reform Act of 1986 (TRA86).
First, the TRA86 phased out tax deductions for interest on consumer debt,
which contributed to a marked shift in
the composition of household debt.
Second, the TRA86 restricted the tax
deductibility of contributions to
individual retirement accounts (IRAs)
for some higher-income households.
This appears to have contributed to,
but is not solely responsible for, the
shift in the composition of some
households’ portfolios of tax-preferred
saving incentive plans. This paper also
discusses the interaction of household
debt and 401(k) plans following the
TRA86. The aspects of the TRA86
focused upon in this paper appear to
represent examples of more typical
responses to tax changes: changes in
the composition of economic activity but
with little change in the real level of
economic activity. This conclusion is
consistent with the hierarchy of taxpayer responses suggested by Slemrod
(1990, 1995) and yields some potentially
relevant implications for fundamental
tax reform.
INTRODUCTION
The current debate on fundamental tax
reform is often described as merely a
choice between an income tax and a
consumption tax.1 This characterization
can easily lead to the general conclusion
that the effects of the Tax Reform Act of
1986 (TRA86) have little to offer in the
way of guidance concerning the effects
of a fundamental tax reform. The TRA86
enacted broad changes in the personal
and corporate income taxes by reducing
marginal tax rates and by broadening
the tax base via a reduction in tax
preferences, but did not embody a
fundamental shift from an incomebased tax toward a consumption tax.
*
Board of Governors of the Federal Reserve System,
Washington, D.C. 20551.
**
The Brookings Institution, Washington, D.C. 20036-2188.
331
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
While the shift to a consumption base is
an important part of fundamental tax
reform proposals, it may not be the only
relevant issue. For example, the flat tax,
which expenses investment at the
business level, is appropriately considered a consumption-based tax. If the flat
tax instead provided depreciation
allowances for investment, rather than
expensing, it would be an income-based
tax (Slemrod, 1995b). Our conjecture is
that, for a number of issues involved
with tax reform, a switch to a flat-taxwith-expensing might not lead to
dramatically different conclusions from
switching to a flat-tax-with-depreciation.2 If so, then at least for some
issues, the crucial point may not be the
distinction between an income tax base
and a consumption tax base, but rather
the desirability of broadening the
current hybrid income-consumption tax
base—whether the ultimate base is
consumption or income—and flattening
the current increasing tax rate structure.
The latter two issues, however, are
exactly the focus of the changes in the
TRA86, and potentially make the effects
of TRA86 relevant for understanding at
least some aspects of the debate on
fundamental tax reform.
out (eliminated) when adjusted gross
income exceeds $40,000 ($50,000) for
joint taxfilers and $25,000 ($35,000) for
single taxfilers. This appears to have
contributed to, but is not solely responsible for, the shift in the composition of
the portion of households’ asset
portfolios allocated to tax-preferred
saving incentive plans, such as IRAs and
401(k) plans. Before the TRA86, IRAs
constituted the majority of total saving
incentive contributions. However, IRA
contributions plummeted following the
restrictions imposed by the TRA86. By
1992, IRA contributions comprised less
than one-fifth of total saving incentive
contributions, while contributions to
401(k) plans grew to constitute about
three-quarters of total saving incentive
contributions.
Household debt and contributions to
tax-based saving incentives can also
interact in important ways. It is important to recall that household saving and
wealth are ultimately net concepts–
assets minus debt. Hence, studies
should also focus on how tax changes
affect household wealth, rather than
just assets or debt. However, these two
components of household wealth, and
the effects of tax changes on household
asset accumulation or household debt,
typically have been analyzed separately.
This paper discusses the interaction of
household debt and tax-preferred saving
following the TRA86.
In this paper, we focus on two aspects
of the tax changes enacted in the
TRA86 and discuss some of their effects
on households’ saving and debt
decisions. First, TRA86 phased out tax
deductions for interest on consumer
debt. This contributed to a marked shift
in the composition of household debt
away from consumer borrowing and
toward mortgages, the interest on
which remained tax deductible.
The aspects of the TRA86 focused upon
in this paper appear to represent
examples of more typical responses to
tax changes. They represent primarily
changes in the composition of economic
activity but with little change in the real
level of economic activity. This conclusion is consistent with the hierarchy of
taxpayer responses suggested by
Slemrod (1990, 1995a) and yields some
potentially relevant implications for
fundamental tax reform.
Second, TRA86 restricted the tax
deductibility of contributions to Individual Retirement Accounts (IRAs) for
higher-income households with a
retirement plan; deductibility is phased
332
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
TAX-PREFERRED ASSETS AND DEBT
The remainder of the paper is organized
as follows. The next section examines
trends in debt before and after the
TRA86. The subsequent section analyzes
interactions between IRAs and 401(k)
plans following the tax changes in the
TRA86. The following section examines
the interaction between households’
accumulation of debt and their accumulation of assets, particularly tax-preferred assets, in the period following the
TRA86. The final section concludes with
a discussion of some implications for the
design and implementation of fundamental tax reform.
in 1980 to 31.6 percent in 1986 to 42.8
percent by 1994. Consumer debt also
grew rapidly over much of this period,
rising at an annual rate of 10.3 percent
in the 1980s and 10.8 percent from
1980 to 1986.
The TRA86 phased out deductions for
consumer interest payments, but
retained the deduction for mortgage
interest for almost all taxpayers.4 This
reduced the price of borrowing through
mortgages relative to consumer debt.
From 1986 to 1994, consumer debt
outstanding grew at only 5.1 percent
per year, and fell from 21 percent of
disposable personal income in 1986 to
less than 19 percent in 1991 through
2
1993.
The composition of household
debt shifted toward mortgages during
the 1970s housing boom, was roughly
2
constant
from 1980 to 1986, and has
shifted further toward mortgages since
1986, even with flat housing prices.
TAX REFORM AND THE ALLOCATION OF
HOUSEHOLD DEBT
Since the early 1980s, the level of debt
held by U.S. households has risen
significantly. Data on aggregate trends
in household debt holdings compiled by
the Federal Reserve Board (1995) show
that nominal household debt, defined
as the sum of mortgage and consumer
debt, grew at an annual rate of 12
percent in the 1970s, 10 percent
between 1980 and 1986, and 8 percent
since 1986. This growth in debt
outpaced inflation, which (measured by
the CPI-U-X1) averaged 7.1 percent in
the 1970s, 4.9 percent between 1980
1 1986, and 3.8 percent from 1986
and
to 1994. Moreover, household debt has
undergone long-term growth relative to
disposable personal income or relative
1 household financial and housing
to
assets.
An increase in mortgage lending can
occur through increased home equity
lending, refinancing of first mortgages
that extract equity, and higher loan-tovalue ratios on new purchases of
homes. Manchester and Poterba (1989)
cite data showing that home equity
loans rose from 3.6 percent of outstanding mortgages in 1980 to 10.8 percent
in 1987. The U.S. General Accounting
Office (1993) cites different data with
similar ratios: 3.8 percent in 1981, 10.6
percent in 1986, and 12.2 percent in
1991. Most of the growth in home
equity lines of credit occurred after
1986: balances rose from $1 billion in
1981 to $32 billion in 1986 and $132
billion in 1991. Eugeni (1993) estimates
that outstanding home equity balances
rose from $268 billion in 1988 to about
$469 billion in 1992. Canner, Fergus,
and Luckett (1989) estimate outstanding home equity balances in 1988 of
between $210 and $265 billion.
Mortgage debt—defined by the
presence of a residence as collateral,
rather than by the use of the loan
proceeds—grew at annual rates of 12.7
percent in the 1970s, 9.7 percent
between 1980 and 1986, and 9.1
percent from 1986 to 1994. Relative to
the value of owner-occupied real estate,
mortgage debt rose from 27.5 percent
333
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
These different studies are roughly
consistent and suggest rapid growth of
home equity lending in the 1980s.5
Home equity lending can account for a
sizable portion of the increase in
mortgage debt before 1986, but a
smaller portion of the increase after
1986. Nonetheless, in the post-86
period, home equity lending may have
played an important role in enabling
households to change the composition
of their debt.
interest payments. They also find that a
dollar of reduced consumer interest is
associated with a 67 to 86 cents
increase in mortgage interest payments.
Using interest rate data from Canner,
Fergus, and Luckett (1988), these
3
estimates
suggest that a dollar in
reduced consumer debt raised mortgage
debt by between $0.87 and $1.11.6
Scholz (1994) uses cross sections from
the 1983 and 1989 Surveys of Consumer Finances. He finds that household
debt rose between 1983 and 1989.
Among higher-income homeowners,
property-backed debt rose rapidly.
Among low-income renters, who
presumably had less access to deductible borrowing after the TRA86, debt
holdings fell.
Mortgage refinancing represents an
alternative way to extract housing
equity. In a 1989 survey reported in
Canner and Luckett (1990), 20 percent
of households with mortgages had
refinanced their mortgage. Of those, 57
percent had extracted equity at the time
of refinancing. The mean and median
amounts extracted were $25,145 and
$15,941. These are roughly similar to
the mean and median for home equity
loans, $22,534 and $15,905.
Maki (1995) uses successive cross
sections of the Consumer Expenditure
Survey. He shows that high income
homeowners reduced their consumer
debt and raised their mortgage debt
after the TRA86, relative to other
households. He also shows that highincome renters did not reduce their
consumer debt holdings relative to other
renters and that households increased
their total debt.
Higher initial loan-to-value ratios (i.e.,
smaller down payments) are another
channel through which mortgage debt
can rise relative to the house value
backing the debt. Data from the Federal
Housing Finance Board (1995) shows
that aggregate loan-to-value ratios on
purchase money mortgages (i.e.,
primary mortgages that are not
refinancings) rose from 72.9 percent in
1980 to 77 percent in 1984, fell to 74.4
percent by 1991, and then rose to 79.9
percent in 1994. Similar time patterns
occur for the proportion of new loans
with loan-to-price ratios that exceed 90
percent.
Engen and Gale (1995) used successive
cross sections of the Survey of Income
and Program Participation (SIPP) in
1984, 1987, and 1991 to look at
household debt. Mortgage debt rose
across all income and age groups.
Median mortgage debt rose by 14
percent from 1984 to 1987 and by an
additional 37 percent from 1987 to
1991. Virtually all of this increase was
due to an increase in the ratio of
mortgage debt to house value, rather
than changes in house value.7 From
1987 to 1991, homeowners with family
earnings above $50,000 reduced their
holdings of consumer debt, while
Skinner and Feenberg (1990) use a
panel of taxpayers from 1984 through
1987 who itemize their tax deductions.
Their estimates imply that limiting the
deductibility of consumer interest in
TRA86 significantly reduced consumer
334
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
TAX-PREFERRED ASSETS AND DEBT
renters in the same earnings classes
raised their consumer debt holdings.
IRAs and 401(k) plans are unlikely to
be perfect substitutes. 401(k) plans are
tied to the work place, while IRAs are
not. 401(k)s usually have employer
matching of employee contributions,
while IRAs do not. 401(k)s and IRAs
generally have different contribution
limits, withdrawal and loan provisions,
and investment opportunities. 401(k)
contributions tend to be regular salary
reductions; IRAs can be funded anytime. For example, people may want
to put some money into a 401(k) but
then keep the flexibility of contributing
more to an IRA at a later date in the
tax year, depending on their income
and expenses. Nevertheless, IRAs and
401(k)s could very well be good
substitutes for some people (particularly
those who hold both 401(k)s and IRAs).
The plans represent alternative ways to
save for retirement, and 401(k)s should
be particularly attractive for high-income
households after the removal of tax deductibility for IRA contributions in 1986.
These studies have important implications for studying household saving
behavior and its response to tax
changes. First, these studies are consistent with the conclusion that the
composition of household debt portfolios is sensitive to the tax treatment of
different types of debt. Second, the
trends suggest the importance of
analyzing the effects of tax reforms on
broad measures of household wealth
which include liabilities as well as assets.
TAX REFORM AND THE ALLOCATION OF
TAX-PREFERRED SAVING
In this section, we examine the relationship between IRAs and 401(k) plans.
Since the early 1980s, tax-based saving
incentives plans, such as IRAs and
401(k) plans, gained tremendous
popularity.8 Total contributions to IRAs,
401(k)s, SEPs, and Keoghs increased
from less than 4 percent of personal
saving in 1981 to about 35 percent of
personal saving by 1985, and then
continued to comprise about one-third
of personal saving through 1992.
However, the restrictions imposed by
the TRA86 on deductible IRA contributions significantly changed the composition of saving incentive contributions.
Before the TRA86, IRAs constituted the
majority of total saving incentive
contributions. However, contributions
plummeted following the change in the
treatment of IRAs enacted in TRA86.
By 1992, IRA contributions comprised
less than 20 percent of total saving
incentive contributions. In contrast,
contributions to 401(k) plans grew
steadily since their tax treatment was
clarified in 1981 and constituted about
three-quarters of total saving incentive
contributions by 1992.
One way to test for substitutability is to
exploit the removal of tax deductibility
of IRA contributions for some higher
income families in the TRA86. If
households find IRAs and 401(k)s to be
substitutes, controlling for other factors,
the decline in IRA participation after
TRA86 should be larger for 401(k)
eligible households than for noneligible
households among income groups who
lost deductibility of IRA contributions.
Poterba, Venti, and Wise (1992) present
evidence related to this issue using data
from the Employee Benefits Supplement
of the 1988 Current Population Survey.
They find that for families with incomes
above $75,000, the IRA participation
rate dropped substantially more for
401(k) eligibles than for noneligibles. In
this group, the IRA participation rate
fell by 57 percentage points for eligibles
compared to 27 percentage points for
ineligibles.
335
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
Engen, Gale, and Scholz (1994) examined the relationship between IRAs and
401(k)s after TRA86, using data from
the SIPP. If 401(k)s and IRAs are substitutes, 401(k)-eligible families whose IRA
deductibility was restricted in 1986
should funnel more money into 401(k)
plans from 1987 to 1991 than eligible
families whose deductibility was not
removed, controlling for other factors
such as income and net worth. They
find that among 401(k)-eligible families,
not being allowed to make deductible
IRA contributions raised 401(k) balances
by $2,538 from 1987 to 1991. This
result is consistent with the hypothesis
that there is substitution between
401(k) plans and IRAs. Moreover, they
note that the average real 401(k)
balance among eligibles in the effected
group rose by about $4,300 between
1987 and 1991. Hence, the removal of
deductibility potentially can account for
half of the increase in 401(k) balances in
the higher-income group affected by the
removal of IRA tax deducibility in the
TRA86.
tion of wealth, where wealth is defined
as the sum of net financial assets
(financial assets minus consumer debt)
and housing equity (house value minus
morgage debt). Their analysis used data
from successive cross sections in 1987
and 1991 of the SIPP. They obtained
several results that point to important
interactions between household assets
and liabilities following the TRA86.9
Thus, there exists some evidence
implying that some households substituted away from IRAs into 401(k)s
following the TRA86. The TRA86
probably contributed to, but is almost
certainly not solely responsible for, the
shift in the composition of households
holdings of tax-preferred financial
assets. This is consistent with the conclusion that the composition of household asset portfolios is sensitive to the
tax treatment of different types of assets.
Second, they split the sample into
homeowners and renters. For renters,
being eligible for a 401(k) has no effect
on holdings of financial assets or net
financial assets. For homeowners,
401(k) eligibility raises gross financial
assets and net financial assets, but has
no effect on a broader measure of
wealth defined to include housing
equity. Third, similar results apply to the
effects of 401(k) participation in a set of
analogous tests that control for IRA
status and other factors.
First, between 1987 and 1991, controlling for IRA status and other factors,
households with at least one worker
eligible for a 401(k) plan did accumulate
more financial assets and net financial
assets than observationally equivalent
households that did not contain a
401(k)-eligible worker.10 But they also
show that 401(k)-eligible households
did not accumulate more wealth when
housing equity is included. House values
rose for eligibles relative to noneligibles,
but mortgage debt grew even faster, so
that housing equity fell for 401(k)eligible households relative to ineligible
households.
INTERACTIONS BETWEEN ASSETS AND
DEBT
The results imply that groups of families
that were eligible for 401(k)s or participated in 401(k)s and that had access to
mortgage debt, which was still tax
deductible after TRA86, raised their
financial assets and net financial assets
relative to other groups; but this
Engen and Gale (1995) examined
interactions between household assets
and liabilities by examining the effects
of eligibility for, and participation in,
401(k) plans on households’ accumula336
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
TAX-PREFERRED ASSETS AND DEBT
increase in one component of their
portfolio was fully offset by reductions
in housing equity, relative to the other
groups. 401(k)-eligible families, or
participants, that did not have access to
tax-preferred debt after the TRA86 did
not raise their financial or net financial
assets relative to other groups. In
summary, we find that no group of
families that was eligible for, or participated in, 401(k)s significantly raised its
wealth (including housing equity) from
1987 to 1991 relative to the
observationally equivalent group of
families that was not eligible or did not
participate. In showing that borrowing
and saving at the household level can
interact in important ways, these results
have direct implications for the effects
of tax changes on household portfolios
and saving.
mental tax reform. First, the anticipation
of tax reform may have important
effects on economic activity that serve
to offset some of the intended effects.
Virtually all analyses of fundamental tax
reform assume that the new system is
unanticipated and is imposed immediately. This eliminates the possibility of
timing responses in the economic
models being used, but does not
eliminate those responses in the real
world. Second, if a fundamental reform
from the current tax system to a consumption-based tax includes transitional
relief for existing capital, then this will
create differential tax treatment across
assets. The studies outlined above
suggest that these tax differences could
create large reshuffling of portfolios. A
case in point is the mortgage interest
deduction. If the deduction is removed,
then we expect households to substitute
out of mortgage debt, either by raising
their invest- ment debt (Maki, 1996) or
by paying down their loan with accumulated assets. If the mortgage deduction
is retained in a switch to a consumptionbased tax, then tax reform will have
created a conduit for tax-deductible
borrowing in a system that does not tax
interest income. Creating such arbitrage
possibilities could lead to large shifting
into mortgages.
DISCUSSION
Slemrod (1990, 1995a) has categorized
a hierarchy of taxpayer responses to tax
reform. The behavioral response most
sensitive to tax reform involves the
timing of economic transactions;
altering the timing of economic activity
in reponse to permanent variations in
the time pattern of tax rates or in
anticipation of future changes in the tax
law. The next most sensitive type of
taxpayer response involves avoidance
activities, including the reallocation of
asset and debt portfolios outlined
above. The smallest responses should be
expected in real economic behavior:
saving, labor supply, etc.11 The evidence
discussed in this paper is consistent with
this hierarchy. We note as well that,
typically, the timing and avoidance
effects are unintended consequences of
tax reform, while the real effects are
intended.
A final note of caution is warranted.
The top few percent of households, by
income or wealth, account for a very
large share of the net wealth accumulation in the United States. There is little
conclusive evidence on how such house
holds responded to the TRA86 (Slemrod,
1995a), but their impact on assets,
debt, and saving in any fundamental tax
reform proposal could prove decisive.
ENDNOTES
This suggests some implications for the
design and implementation of funda-
We thank Jane Gravelle for her comments on this
paper. All opinions are our own and should not be
337
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 331-39
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
1
2
3
4
5
6
7
8
9
ascribed to the staff, officers, or trustees of the
Federal Reserve Board or The Brookings Institution.
A third possibility is a wage tax. Because future
consumption may be financed only from existing
assets and future wage income, a consumption tax
that allows for transitional tax relief on consumption financed out of existing assets is essentially a
wage tax.
Note also that a consumption-based flat tax would
only exempt the portion of the overall return to
capital that reflects the opportunity cost of capital.
The portion of the return to capital that reflects
rents would be taxed in the same way under both
a consumption-based and an income-based flat tax
(Bradford, 1996).
See Engen and Gale (1995) for a more detailed
discussion of these trends in debt.
The phaseout of deductibility of consumer interest
occurred over five years. Deductibility was retained
on debt backed by a taxpayer’s first or second
residence, up to the taxpayer’s basis in the
property. The Omnibus Budget Reconciliation Act
of 1987 restricted deductibility of mortgage
interest to the first $1 million of acquisition debt
and the first $100,000 of home equity loans. Maki
(1995) provides further information.
Besides tax policy, the growth in home equity
lending has been attributed also to changes in
home values, changes in banking laws, and other
factors. See GAO (1993) and Canner, Fergus, and
Luckett (1988, 1989).
Canner, Fergus, and Luckett (1988) show average
rates in 1984 through 1987 of 11.6 percent for
home equity lines of credit, 18.4 percent for credit
card debt, 12.1 percent for new 48-month car
loans, and 15.3 percent for 24-month personal
loans. If the average rate on consumer debt (the
last three categories) is 15 percent, the estimates in
Skinner and Feenberg (1990) suggest that a dollar
reduction in consumer interest corresponds to a
$6.67 decline in consumer debt. At an 11.6
percent rate on home equity loans, a 67 (86) cent
increase in mortgage interest corresponds to an
increase of $5.78 ($7.41) in mortgage debt.
Hence, reducing consumer debt by a dollar would
raise mortgage debt by between 87 cents (5.78/
6.67) and $1.11 (7.41/6.67).
The median house value (1991 dollars) in the SIPP
was about $77,000 in 1984, $79,000 in 1987, and
$75,000 in 1991. These patterns are consistent
with data reported by Poterba (1991) on U.S.
housing prices. The mean ratio of mortgage to
house value in the SIPP rose 9 percent from 1984
to 1987 and 24 percent from 1987 to 1991.
See Engen, Gale, and Scholz (1994, 1996) for a
more detailed discussion of these trends in taxbased saving incentive plans.
See Engen, Gale, and Scholz (1996) also for more
discussion of the interaction between households’
contributions to tax-preferred 401(k) plans and
10
11
their accumulation of tax-preferred mortgage debt.
Poterba, Venti, and Wise (1995) obtained similar
findings for gross financial assets using similar data
from the SIPP.
Engen (1994) and Engen and Gale (1996) explicitly
analyze the potential real effects of fundamental
tax reform on household saving. These studies
conclude that switching to a consumption-based
tax would modestly increase household saving. In
assessing the effects of fundamental tax reform,
Engen and Gale (1996) note the importance of
realizing that in the current hybrid incomeconsumption tax, much of household saving is
already done through tax-preferred forms such as
pensions, saving incentive acounts, and owneroccupied housing. Sabelhaus (1996) documents
the importance of tax-preferred saving in aggregate household saving.
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