Opinion Editorial | |
| November 13, 1996 | |
Don't Index Capital Gains, Abolish ItBruce Bartlett
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Late in the campaign, Republican vice-presidential candidate Jack Kemp raised a new issue in the tax debate. He said that, if elected, Bob Dole would issue an executive order indexing capital gains for inflation. The idea was quickly endorsed by Wall Street financier Ted Forstmann, who said it was "the right thing to do both morally and ethically."
The tax code currently does not differentiate between an asset's real increase in value and the increase due solely to inflation. On assets that have been held for a long time, a considerable part of their value may simply reflect inflation.
Taxes on the inflationary component can easily exceed any real increase in an asset's value, meaning the tax rate on real gains can be 100 percent or more. Indexing would fix this problem by increasing the basis for taxation by the inflation rate, with taxes applying only to gains in excess of inflation. The effect of indexing would be to greatly reduce the tax rate on capital gains.
Unfortunately, there are significant legal, administrative and technical barriers to capital gains indexing. The first problem is legal.
In 1992, Charles Cooper, a former assistant attorney general during the Reagan administration, wrote a paper arguing that the Treasury Department had the power to index capital gains by regulation. However, when this opinion was reviewed by George Bush's Justice Department, Atty. Gen. William Barr ruled that such authority did not in fact exist.
The administrative barriers are also formidable. Figuring out exactly what inflation adjustment should apply to shares of stock that may have been acquired at different dates over a long period of time would be a nightmare of complexity. In the case of tangible assets, such as buildings, any improvements would have to be indexed separately. And matching indexed gains against losses would be extremely difficult.
Another administrative problem is that unless debt is also indexed, capital gains indexing could simply become a tax dodge. The reason is because inflation not only increases the value of assets, it also raises interest rates. But interest paid on money borrowed for investment is tax deductible. Thus people who borrow to purchase capital assets are already compensated for inflation by deducting interest that includes an inflation component. If gains are indexed, borrowers should only be allowed to deduct interest less the rate of inflation. This would be extremely complicated.
Finally, there are technical problems about what inflation rate to use when indexing capital gains. The consumer price index might not be appropriate for this purpose because of the relatively limited number of goods included in the index. Also, widely known problems with the index are believed to substantially overstate the true rate of inflation. For example, the Bureau of Labor Statistics has great difficulty adjusting prices for increases in quality and incorporating new products into the index while maintaining continuity.
For these and other reasons, indexing is a bad idea. It is better to continue pushing for a reduction in the tax rate on capital gains.
Historically, the problem of inflation has been a major justification for having a lower tax rate on capital gains than on other forms of income. Consequently, the institution of indexing might make it impossible to ever cut the tax rate on capital gains.
The best approach would be to abolish the capital gains tax. Capital assets only have value because of the flow of income they generate. But since we also tax dividends, interest and rent, the capital gains tax is really a double tax in most cases.
Bruce Bartlett is a senior fellow with the National Center for Policy Analysis.
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