Politics & Policy

Inflate This

Stimulus needs a supply-side touch -- Bush can give it

To most Americans, an $800 rebate check from the U.S. Treasury sounds like a great idea. That’s $800 to pay old bills, or to save, or to take a nice vacation in Florida this winter.

Laudable as giving back to taxpayers is, this one-time rebate is comparable, as Russell Roberts puts it, to removing water from the deep end of a pool and pouring it into the shallow end: It merely moves money around. It cannot produce economic growth, create wealth, or prevent a recession.

President Bush and the Democrats appear to be in agreement that such a “stimulus” is needed. On Capitol Hill Wednesday, House conservatives, led by Rep. Jeb Hensarling (R., Tex.) proposed a stimulus package that speaks the language of supply-side economicsalways a foreign tongue to President Bush, despite his affinity for cutting taxes. The conservative plan includes full expensing of business assets, a corporate income-tax cut, and a simplification of the corporate capital-gains rate.

As strong as their ideas are, these conservatives are hopelessly outnumbered by the Democrats who control Congress. Democrats prefer higher taxes, not lower ones. Moreover, they are especially opposed to tax cuts for high earners, even if these cuts remove barriers to investments that create jobs and drive the economy.

The conservatives have one proposal, however, that would require no legislative action — at least according to some experts. That is the indexing of capital gains to inflation. The idea is simple. Let’s say you bought a house on Capitol Hill in 1990 for $100,000. You sold it in 2006 for $700,000. In nominal terms, you made $600,000, and that is the number you’d currently use to pay your capital-gains tax. But if you adjust for inflation, you realize the original price was $157,000 in 2006 dollars. Your tax exposure would be reduced from $600,000 (minus exemptions) to $543,000.

The same would apply to a $100 stock bought in 1990 and sold in 2006. If it is worth $150 today, it has actually declined in value, having failed to keep up with inflation. But under current law, the seller must pay tax on the $50 “gain.”

“People are taking losses all the time and having to pay taxes,” said Pat Toomey, president of the Club for Growth. “It’s hard to believe that Congress ever intended that.”

To index capital gains to inflation is essentially to cut taxes on investment. It mitigates a government-created obstacle that all investors face when they decide how much money to invest, and it makes it cheaper to move away from under-performing positions. This means, on the margin, more investment in companies that employ Americans and sometimes even create new markets for goods and services through innovation.

Can the administration really make this change through executive order? There are many opinions on this topic. But the case for it was made well in 1992, in a 94-page memo by respected Washington attorney Charles J. Cooper, who had been asked by the National Chamber Foundation to examine the question. He wrote, “[W]e believe that a regulation indexing capital gains for inflation should and would be upheld judicially as a valid exercise of the Treasury’s interpretative discretion under the [Internal Revenue Code].”

In short, Congress did not define the word “cost” in the Internal Revenue Code, so it is up to executive regulators to do so in the context of the capital gains tax. For current tax purposes, the “cost” of a home purchased in 1990 could be considered in 1990 dollars, or in current dollars. The discretion rests with the treasury secretary.

Cooper was cautious, writing that the question “is admittedly a close and difficult one” and that it “depends heavily on the standard of judicial review that would apply to such a regulation.” Still, if some Grinch — perhaps a liberal Democrat in Congress – wants to sue the government to raise taxes, this would itself be a political victory for Republicans.

Both economically and politically, an executive order to index capital gains for inflation is a winner. Looking down the road, it even sets a trap for the future Democratic president who decides to discontinue the practice, effectively raising taxes by fiat.

The Treasury Department has always been cool to the idea. Its general counsel, Timothy Flanigan, responded to Cooper’s memo in 1992 by arguing that “[a]lthough the term ‘cost’ is not further defined in the Code, since the inception of the federal income tax system following ratification of the Sixteenth Amendment in 1913, Treasury has consistently interpreted the statutory term ‘cost’ to mean price paid.”

This is not really an argument for that interpretation. It is, however, an admission that Treasury is standing by its age-old interpretation of an undefined term penned in an era before fiat money. In the 34 years before the Internal Revenue Code was written and the capital gains tax created, annual inflation had averaged 0.1 percent and was barely relevant. A lot has changed since then, but Treasury’s reading of “cost” has not.

When presented with the case, Bush’s Treasury Department has also resisted inflation indexing. But the idea gains currency as Hensarling and his conservative allies in the House circulate it in the form of legislation. In a January 23 letter, they even urged Bush and Secretary Henry Paulson to adopt it by executive order.

“The Democrats want to send checks to people who don’t pay taxes, because that’s what they do,” said Toomey, referring to the proposed rebate checks. “But if they get some of that stuff, maybe we could actually include some things that will stimulate the economy.”

President Bush frets that he may be remembered for the Great Recession of 2008. By adopting inflation indexing, he could really stimulate a slowing economy, and he could do it without a fight in Congress. More importantly, he would end the unjust practice of forcing Americans to pay taxes on gains they never actually realized.

– David Freddoso is an NRO staff reporter.

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