If You Want to Index the Capital-Gains Tax, Do It the Right Way

(Pixabay)
Use legislation, not executive action.

NRPLUS MEMBER ARTICLE A fter some waffling, it appears that President Trump is again thinking about “indexing” the capital-gains tax.

The case for doing so is simple enough. The tax, of up to 20 percent, applies when you sell investments or property that have appreciated in value, and there is no adjustment for inflation. So if your $100 worth of stock grows to $110 over a certain period, and prices in general rose 10 percent over that same period, you’ll owe tax on a $10 “gain” that is not even real. Tax experts across the political spectrum agree this is not ideal. If we’re going to tax capital gains, the money should come from investors who actually made gains.

But there are serious legal and policy problems with making this change the way the administration is considering: simply reinterpreting the word “cost” in current law to refer to the inflation-adjusted cost rather than the nominal price paid.

This would be a big change, cutting revenue at least $10 billion a year — in the ballpark of 10 percent of what the tax brings in — at a time when we’re already running trillion-dollar deficits. And if the president does this himself, he can’t raise the overall capital-gains rate, hike other taxes, or cut spending to compensate. This is not a decision to be made lightly, and it’s the kind of change that should inspire conservative skepticism when pursued by executive fiat. (Liberal skepticism, of course, is also a given, because the capital-gains tax is overwhelmingly paid by the richest Americans.)

Legally, it’s far from clear this is even allowed, as Daniel Hemen and David Kamin have nicely explained in the Yale Journal on Regulation. The law at issue was written in 1918, and it has always been interpreted to refer to nominal (i.e., not inflation-adjusted) costs. Other portions of the tax code explicitly require inflation adjustments, suggesting that Congress knows how to do this when it wants and did not wish to in this case. Further, in subsequent laws, Congress decided to tax capital gains at a lower rate than ordinary income in part because capital gains include inflation. There is simply no sign that Congress intended to allow for an inflation adjustment, or that it intentionally delegated this choice to the executive.

In 1992, the George H. W. Bush administration considered making this very same move but ultimately decided it didn’t have the legal authority to. If Trump proceeds, his action will likely provoke a court challenge, the biggest questions in which will be (1) how much courts should defer to the executive branch when it stretches the meaning of laws and (2) whether any plaintiff has standing to sue, given how few people would face concrete harms from a tax cut given to other people. (Blue states, Democratic members of Congress, and some entities hurt by the change for technical reasons are some possible plaintiffs.)

There are major policy problems here too, and not just the loss of revenue. Indexing the capital-gains tax but not certain other provisions of the tax code, such as deductions for interest paid on loans, will create “arbitrage” opportunities where people can shift money around to evade taxes. Here’s an example from Hemel and Kamin:

Imagine that a taxpayer buys an asset for $100 that is fully financed by a loan. Assume that the real interest rate is zero, that the inflation rate is 10%, and that the nominal interest rate on the loan is 10% as well. One year later, assuming no change in the real value of the asset, the asset will be worth $110 on account of inflation. If basis is indexed for inflation, the taxpayer can sell the asset for $110 and recognize no taxable gain. Assuming that the interest is properly allocable to a trade or business, the taxpayer can claim an interest deduction of $10 with no offsetting gain, despite the fact that the taxpayer is in the same pre-tax position as previously. Put differently, the effort to eliminate the taxation of phantom gains leads to opportunities for the creation of phantom losses.

The lender in that case might owe taxes on his $10 gain — but not if it’s a non-profit, and these taxes can be lower than what would be owed on a capital gain anyhow.

Not to mention the trivial effects on growth. The Tax Foundation, a right-leaning think tank generally bullish on the economy-boosting effects of tax cuts, puts the long-run GDP boost at 0.1 percent.

Reworking how we treat capital gains could be a worthy project for Congress as part of further tax reform. But if Congress won’t do this, presidential action is not a good substitute.

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