Back in 1986, when I was a Legislation Attorney at the Joint Committee on Taxation, I was a member of the staff team that worked on drafting and designing the passive loss rules, which famously dinged tax shelters in general, including those that used real estate investments. (Shelters were more general than this, however – e.g., cattle feeding shelters were another big favorite, and I remember one which involved marketing master cassette videotapes of Vincent Price narrating passages from the Bible.)
So it's been interesting – a trip down memory lane and all that – to see the passive loss rules resurfacing in re. Trump's taxes. But this has actually followed two distinct channels. First, however, a bit of background.
The passive loss rules' basic aim, in very broad overview, is as follows. At the time of enactment, people with sources of high taxable income that could not directly be tax-massaged very much (e.g., salaried professionals such as doctors, dentists, and lawyers) were buying investments that were designed to generate large tax losses, without commensurate economic losses. These losses were used to offset the positive taxable income, hence “sheltering” it. So the rules said: If you invest in a passive activity, i.e., one in which you do not “materially participate” or that is a rental activity (since those often require little work), you generally can't deduct any resulting passive losses against your nonpassive income. This appears to have been quite effective in shutting down the 1980s-era tax shelter industry, although as usual there are empirical questions about what caused what.
In 1993, or six years after I had left the JCT and started my academic career,Congress enacted a special exception to the passive loss rules, permitting people who qualified as real estate professionals to avoid having their rental real estate activities treated as passive. This meant that their tax losses from these activities could indeed be deducted against other positive income.
Anyway, onto the dual Trump connection. First, yesterday's NYT had an editorial decrying Trump's tax avoidance, and singling out theexception to the passive loss rules for real estate professionals cas case in point. The Times rightly notes that this would have permitted Trump to deduct tax losses from rental real estate against “earnings from The Apprentice and money made from selling steaks and neckties.”
Fair enough. But I'll admit that I never considered the passive loss rules' impact on that type of circumstance as being really at its core, which (as noted above) had more to do with the mass-marketed tax shelter industry of that era.
Second, someone sent me the tape and transcipt of a 1991 Donald Trump CSPAN appearance, as a witness at a House hearing about real estate policy, available here. (You have to scroll down a bit for Trump's testimony.) Interesting stuff.
An initial point is that reading this transcript increases my estimate of the probability that the Trump of today is suffering from age-related dementia. (This is actually something that I have been wondering about.) He is more coherent and focused – able to speak in complete sentences and pursue a single line of thought – in the 1991 tape & transcript than he appears to be today. But what he has to say about tax policy is rather amusing.
In particular, he denounces the 1986 Tax Reform Act, and the passive activity rules in particular, as a horrible disaster for real estate. Given his line of business, he is understandably upset that the passive loss rules took passive investors out of the market, thereby (he asserts) depressing real estate prices and activity.
It does, however, feature a comical misunderstanding by Trump of how market economies operate. He says we are now in a Soviet-style world where there are no “incentives” to invest.
But what he means by no “incentives” to invest is that the only reason to invest would be expecting an actual (and pre-tax) profit. So, for Trump in 1991, “Soviet-style” means market-based, whereas the approach that's actually closer to being Soviet-style – having the government, through tax policy, decide where investment capital should go – is supposedly its opposite.
At least Trump in 1991 sufficiently had the courage of his convictions to say that tax rates should be much higher than they were after 1986 – not, mind you, to raise revenue or in pursuit of tax fairness, but simply to make the tax incentives (if delivered in the form of deductions) more powerful than they would otherwise be.
I know of no other case in which someone called for higher tax rates just to make tax incentives more powerful. I recall from 1986 that the charitable community was very aware that lower tax rates would be expected to reduce charitable giving, all else equal, but the use they made of this was more to argue that something else should be done for them than to say that rates should stay high just for their convenience.
Needless to say, lower tax rates don't have to imply weaker tax incentives for particular activities. E.g., Congress could provide percentage credits in lieu of deductions. An example would be combining (a) reduction of the top tax rate from 50% to 28% with (b) conversion of charitable deductions into 50% credits, so that if you gave $1 to charity you got a 50-cent credit against your overall tax liability.