The Trump Administration Should Index the Capital Gains Tax to Inflation

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Posted by Alexander Hendrie on Monday, May 1st, 2017, 10:55 AM PERMALINK

President Donald Trump has repeatedly promised he will enact pro-growth changes to the tax code to increase economic growth, create more jobs, and increase wages.

While the best way to achieve this goal is working with Congress to pass tax reform legislation, there are also other ways to achieve this. One change the Trump administration can make to the code immediately is directing Treasury to account for inflation when calculating capital gains taxes as outlined in a 1992 legal memo commissioned by the National Chamber Foundation and prepared by the law firm Shaw, Pittmann, Potts & Trowbridge.

The capital gains tax is one of several layers of taxation in the existing tax code. This tax is levied on income that has already been taxed at the individual level and is then reinvested into the economy. This extra layer of taxation creates a bias against savings and suppresses productivity and new investment. In turn, this hinders the creation of new jobs, higher wages, and increased economic growth.

A capital gain is defined in the tax code as the value of an asset at the time of sale minus the “cost.” Since the inception of the IRC, Treasury has interpreted “cost” to mean the original purchase price at the time of the purchase.

This interpretation fails to take into account any gain that is based on inflation. No real value has been added to an asset so no additional taxes should be owed. According to research by the Tax Foundation, about 50 percent of capital gains are actually from inflation.

Ending this inflation tax would reduce a barrier to reinvesting in the economy, which would lead to stronger growth, just as President Trump has promised. There is a clear policy rationale for indexing capital gains taxes to inflation. Similarly, there is a clear legal justification for Treasury to do so.

Current Law Distorts Against Long-Term Decision-making

Without an inflation index, the capital gains tax discourages long-term investment by exposing long-term investors to greater inflation risk than short-term investors.

For example, an investor who makes a capital investment of $1,000 in 1980 and sells that capital for $2,000 in 1996 will be taxed for a $1,000 gain. However after adjusting for inflation, the investor realized a gain of just $241 (1,000 in 1980 - $1759 in 1996).

By comparison, an investor that made a capital investment of $1,000 in 1996 and sold for $2,000 just one year later has a much higher real after-tax gain. As a result, the current tax code provides incentive for speculation, as opposed to long-term investment.

A basic principle of any equitable tax system is that taxpayers in equivalent circumstances should pay equivalent taxes. Referring to our earlier example, suppose that our long-term investor sells his $1,000 investment for $1,000, or no gain. In real economic terms, these two taxpayers are in identical circumstances. Both saw no real capital gain.

However, one will pay a tax on $759 of “income,” while the other pays no tax at all. In the absence of inflation-indexing, many investors are forced to pay capital gains taxes on real capital losses. In such circumstances, capital gains taxes amount to a levy on capital. Intuition tells us that a capital levy was never the intent of Congress when it created the IRC in 1913, or its many revisions thereafter. The history of congressional action concerning capital gains and the IRC since 1941 supports this conclusion. 

Clear Legal Justification for Indexing Cap Gains to Inflation

As noted by the 1992 legal memo, there is clear justification for Treasury to interpret “cost” to account for inflation.

This decision is based on three specific questions:

1.       Is the tax code sufficiently ambiguous to allow for administrative interpretation of “cost” in this instance?

2.       Does regulatory or legislative history offer an implied interpretation that could preclude Treasury’s authority?

3.       Does existing case law support Treasury authority in this specific instance?

First, the tax code does not specifically define the term “cost”. The tax code does define a capital gain in terms of its “adjusted basis” and specifically defines “basis” in terms of “cost.” Based on the precedent established by the Supreme Court under Chevron U.S.A. v. Natural Resources Defense Council., the memo concludes that the tax code is sufficiently ambiguous.

Therefore, as the memo notes, “interpreting cost to refer to the true economic consequences of the taxpayers investment is as reasonable as interpreting it to refer only to the nominal dollars expended to purchase the asset.”

Second, the legislative history of the tax code, and capital gains supports Treasury’s discretion. In 1918, when capital gains were explicitly written into the tax code, the economics of prices was well established, but not yet a part of mainstream public policy discussions. Virtually no questions of inflationary effects were raised in debate.

It could be argued that Congress’ repeated failure to write specific inflation-indexing language into the tax code amounts to an implicit rejection of such an interpretation of “cost.” However, two factors undercut this assertion. First until 1986, capital gains enjoyed a significant preference, most often a 50% exemption. In congressional debates, this exemption was frequently cited as sufficient to offset inflation’s effect on capital gains. In 1986, Treasury recommended an inflation index and elimination of the preference in its original proposal for fundamental tax reform.

Unfortunately, Congress took the advice to eliminate the preference, but ignored inflation indexing. Since 1986, inflation indexing legislation has been passed in both houses of Congress, but has never been enacted.

Third, existing case law is a strong argument for Treasury discretion. As noted by the study, numerous cases directly and specifically support Treasury discretion. Even before Chevron, courts showed great deference. The most poignant and pertinent is U.S. v Ludey (1927). Ludey dealt with the issue of adjustment to “cost” in capital gains. The court agreed with Treasury, which had defined “cost” with an adjustment for depreciation as Congress did not intend to tie the agency to a particular definition of “cost,” to the exclusion of other economic principals.



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