Treasury Should Index The Calculation of Capital Gains Taxes To Inflation

Posted by Alexander Hendrie on Tuesday, January 16th, 2018, 9:00 AM PERMALINK

The Trump tax reform plan enacted into law late last year is already driving stronger economic growth, higher wages, and more job creation. While this legislation is a landmark achievement, there are other steps the administration can take to promote stronger economic growth, such as through indexing the calculation of capital gains taxes to account for inflation.

When paying capital gains taxes, taxpayers generally pay tax on an asset calculated as the sale price less the purchase price. However, this fails to account for gains that are purely from inflation and are not a true gain.

For example, an investor makes a capital investment of $1,000 in 2000 and sells that investment for $2,000 in 2017 will be taxed for a $1,000 gain at a top capital gains tax rate of 23.8 percent. After adjusting for inflation, the “true gain” is much lower – just $579. (1,000 in 2000 - $1,421 in 2017).

According to a 2013 analysis by the Tax Foundation, the average effective capital gains tax rate excluding gains based on inflation between 1950 and 2012 was 42.5 percent, nearly twice today’s 23.8 percent top capital gains tax rate.

The ability of Treasury to index capital gains taxes to inflation has been analyzed by lawyers Charles J. Cooper, Michael A. Carvin and Vincent Colatriano in a 1993 legal memo published in Virginia Tax Review, and again by Cooper and Colatranio in a 2012 legal memo published in the Harvard Journal of Law and Public Policy.

[Read the 1993 legal memo by Cooper, Carvin & Colatriano here]

[Read the 2012 memo by Cooper and Colatranio here]

According to these analyses, federal law is sufficiently ambiguous to allow Treasury to index capital gains taxes to inflation. In addition, there is significant judicial precedent for indexation and no explicit Congressional opposition to indexation.

Federal Law Grants Treasury the Flexibility to Index the Calculation of Capital Gains Taxes to Inflation

Historically, the tax code has defined taxable income or “gain” when calculating capital gains tax owed as the difference between the historical cost of the asset and the sale price of the asset less certain adjustments. However, the use of historical cost is not explicitly required under law.

The tax code states that tax owed on capital gains is “the gain from the sale or other disposition of property… [in] excess of the amount realized therefrom over the adjusted basis…”

The “adjusted basis” is defined as the cost of such property after depletion, depreciation and other expenses. This means that “cost” is defined as the original purchase price after adjusted basis.

However, this terminology is not explicitly defined in law and Congress has not passed legislation defining cost or requiring the use of the current definition of cost.

In fact, the IRS has used regulatory discretion in defining cost in the past.

In 1918, Treasury decided that an asset’s cost was not strictly purchase price but was purchase price less depreciation and depletion taken by the taxpayer prior to sale. Treasury never explicitly defined cost until 1957, when they defined it as “the amount paid for… property in cash or other property.”

Relevant Judicial Precedent Suggests Treasury Has the Authority to Add an Inflation Index

Under the precedent set by the Supreme Court in Cheveron U.S.A. v. National Resources Defense Council (1984), the ability of Treasury to add an inflation adjustment hinges on whether the new definition of “cost” is plausible.

If the statute is not explicit, the question becomes whether the new reading of the law is based on a permissible construction of the statute. As noted above, the statute is not explicit in defining cost.

In addition, recent legal precedent – specifically three recent court cases suggests that there is precedent for “cost” to be reinterpreted by Treasury to include inflation:

  • In Verizon v. FCC (2002) the Supreme Court affirmed that the term “cost” was ambiguous. In this case, the petitioners, local exchange carriers, argued that the term “cost” meant historical cost and by using an expanded definition that the FCC was not properly implementing rate-setting provisions under the Telecommunications Act of 1996 (TCA).
    • Under Sec. 252(d)(1) of the TCA, local exchange carriers were required to charge a competing local carrier for a network element, “the cost… of providing the… network element…”
    • The court unanimously rejected the petitioner’s argument that required the plain meaning definition of “cost.” The court instead found cost was “protean,” “a chameleon,” and “virtually meaningless.”
  • In National Cable & Telecommunications Ass’n v. Brand X Internet Services (2005), the Supreme Court affirmed the right of an agency to interpret an ambiguous provision of the law. Specifically, the court ruled that judicial precedent does not prohibit an agency from interpreting an ambiguous statute.  
    • This means that Treasury is only prohibited from adding an inflation index if Section 1012 of the code explicitly defines “cost” as the price paid to purchase the property (which it does not.)
  • In Mayo Foundation for Medical Education & Research v. United States (2011), the Supreme Court affirmed that the Chevron doctrine applies to Treasury regulations.
    • In this case, the petitioner argued that Chevron does not apply to the tax code and that the precedent built in National Muffler Dealers Ass’n v. United States (1979) should instead apply.
    • The Court rejected this argument and found that Chevron fully applies to the tax code.


Relevant Legislative History Shows Support for Adding an Inflation Index

  • While Congress has not enacted an inflation index into law, inaction should not preclude Treasury from having regulatory authority in any way. Lawmakers have done nothing to eliminate or prevent indexation. In addition, Congress has indexed numerous other tax provisions to inflation, including individual income tax brackets.
  • Modern history indicates significant support in Congress for indexing the calculation of capital gains taxes to inflation:



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