The Case For The Tax Cut

Policy Reports | Taxes

No. 226
Sunday, August 01, 1999
by Bruce Bartlett

Capital Gains Indexing

Figure VIII - Real Capital Gains by Income%2C 1993

Another object of the Clinton Administration's ire is the tax bill's capital gains provisions. The bill would cut the tax rate on long-term capital gains to 18 percent, but this is not really a tax cut because current law already provides that the current 20 percent capital gains rate will fall to 18 percent after next year. The key provision is indexing capital gains for inflation.

For economists, the concept of income has always meant real income; that is, nominal or money income adjusted for changes in the general price level, by means of some appropriate index such as the Consumer Price Index. However, despite this universally held view among economists, the tax law has traditionally taxed nominal income as if it were real income. It was not until 1981 that the first provisions were added to the Tax Code partially adjusting automatically for inflation. However, much of the Code remains unindexed, resulting in economic distortion and unfairness. In particular, capital gains are not adjusted for inflation.

"The tax law has traditionally taxed nominal income as if it were real income, instead of adjusting for inflation."

The standard economic definition of income used by tax theorists for more than half a century was developed by Robert M. Haig and Henry Simons, both of whom strongly advocated inflation indexing of capital gains for tax purposes. Simons conceded that most capital gains are "largely fictitious" once inflation into taken into account. In principle, he said, tax law should adjust gains and losses for changes in the price level. "Considerations of justice demand that changes in monetary conditions be taken into account in the measurement of gain and loss," Simons wrote in 1938.23 A long line of major tax theorists have consistently held to the Haig-Simons view regarding the impact of inflation on capital gains down to the present day.24

Thus it is well established that as a fundamental matter of principle, capital gains ought to be adjusted or indexed to inflation. And a considerable amount of analysis has shown that the failure to do so has caused great harm to millions of taxpayers.

The first important empirical study of the impact of inflation on capital gains was done by economists Martin Feldstein and Joel Slemrod in 1978. They found that the $4.5 billion in nominal capital gains on corporate stock reported by taxpayers in 1973 would actually have been a $1 billion loss had capital gains been indexed to inflation. But because inflationary gains were taxed as though they were real, taxpayers paid almost $500 million more in taxes that year than they should have.25 Other studies have come to similar conclusions.

  • In 1977, investors paid taxes on $5.7 billion of nominal capital gains on corporate stock. When adjusted for inflation, these gains were actually a $3.5 billion loss.26 This suggests that more than $1 billion in excess taxes were paid that year on fictitious gains.27
  • In 1981, they paid taxes on $17.7 billion of nominal gains that were really a $5 billion loss when adjusted for inflation.28 The excess tax bill came to $2.8 billion.
  • In 1993, gross gains on all assets except bonds were $81.4 billion. Under current law loss limits, real gains were $32.4 billion less. But with no loss limit, the nominal gains turned into a $19.4 billion loss.29 The excess tax bill was at least $7.7 billion.

"Indexing does more to help the middle class than the rich."

Perhaps the most remarkable study of the impact of inflation on capital gains, however, was done by economist Robert Eisner in 1980. He looked at aggregate capital gains from 1946 through 1977 and found that over this entire period there were no real capital gains whatsoever. On balance, Eisner found, households suffered a real loss of $231 billion on nominal gains of almost $3 trillion.30 Commenting on the Eisner study, Alan Blinder conceded that "most capital gains are not gains of real purchasing power, but simply represent maintenance (or rather partial maintenance) of principal in an inflationary world."31

The result of taxing inflationary gains as if they were real greatly increases the tax burden on capital. The effective tax rate can easily exceed 100 percent.32 Ironically, the main burden of the excess taxes actually falls more on those with low incomes than the wealthy. As Figure VIII indicates, in 1993 every income class except those at the very top suffered real losses on their capital gains realizations, and thus paid taxes on nonexistent gains.33 Consequently, indexing does more to help the middle class than the rich.

Finally, it is important to recognize that historically reductions in the capital gains tax rate have strongly stimulated growth. Indeed, according to a recent study, the 1997 reduction from 28 percent to 20 percent paid for itself. Taxes from stronger growth, higher asset prices and greater turnover raised more revenue than was lost due to the rate cut.34

Continuing to tax inflationary gains is unfair and harmful to the economy. Contrary to the Clinton Administration's assertions, the middle class will be the main beneficiaries of the congressional indexing plan.

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