Indexing capital gains for inflation is more trouble than it’s worth

This week, President Donald Trump remarked that his administration is looking into cutting the tax on capital gains. It is not clear whether the administration is still thinking about indexing the basis of capital gains for inflation, or if they will support legislative efforts to cut the capital gains tax. According to comments by Treasury Secretary Steve Mnuchin, the goal is to create a contrast with former vice president Joe Biden — who is proposing to raise taxes on capital gains — and to help the economy recover from the COVID pandemic.

Under current law, individuals determine their capital gains
(or losses) by taking the difference between the sales price of an asset and its
basis (the value of the asset when it was acquired). An asset may generate a
gain due to real increases in value, inflation, or both. To the extent that
inflation contributes to a taxpayer’s capital gains, capital gains taxes are
overstated.

Indexing for inflation would allow taxpayers to adjust the basis to account for changes in the price level over time. Thus, capital gains taxes would only apply to real gains.

Via Twenty20

Over the past year, several analysts have highlighted some of the challenges with indexing capital gains for inflation. Indexing gains for inflation is surprisingly complex. Indexing capital gains without indexing other types of capital income (and capital expenses) can create tax avoidance opportunities. Moreover, it is not clear whether Treasury has the authority to index gains without congressional approval. And even if it were legal, this is a debate best left for Congress to consider.

It’s also unlikely that indexing capital gains for inflation
would provide the economy a meaningful boost.

Capital gains taxes impact the economy through the incentive to save. In a simple closed economy, capital gains taxes can adversely affect economic output by reducing the amount of saving available to finance productive investment. The US economy, however, is not a closed economy. Businesses can receive financing from either domestic or foreign savers. Thus, the tax treatment of saving in the United States — which includes the tax rate on capital gains — matters less than the tax treatment of businesses.

Still, indexing would not have a large impact on the after-tax return to saving. Under current law, many assets that generate gains are shielded from taxation because they are held in tax-preferred saving accounts (401ks, IRAs) or deferred until death when the gains are ultimately forgiven. In 2014, the Congressional Budget Office estimated that about 66 percent of corporate equities held by Americans do not face the individual income tax. Among taxable assets, the effective tax rate on capital gains is low and, counterintuitively, inflation matters less because taxpayers can delay the realization of capital gains.

Reducing the tax burden on saving and investment is a laudable goal. However, indexing capital gains for inflation without any other changes is more trouble than it’s worth.

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