Is there a reason why the factory puts in tall gears for automatics?

If not, can I put in a 3.42 axle ratio in my '88 Iroc-Z 350 700R4?

 

You can put whatever gear ratio you want in your car. Just recalibrate the speedo.

The 700R4 didn't really get what you would call a performance gear ratio in the diff unless it was an underpowered V6. The torque of a 350 through the low first gear of the 700R4 can easy spin the tires if the ratio is too high. 3.27 was a performance ratio for the 350 but more common is the 2.77. That way you can still get a deep gear multiplication through the 700R4's 3.06 first gear and then get low engine rpms while cruising down the highway in OD.

My truck has a 4L80E tranny. Same gear ratios as a TH400 but also has an OD. The 28" tall tires are powered by 4.10 gears in the diff. At 60 mph, engine rpms are around 2800.