Congressman Devin Nunes has introduced House Bill HR 6444 to provide inflation indexing for capital gains
Support is growing among Republicans in Washington to shield capital gains from the ravages of inflation. President Trump’s economic adviser Larry Kudlow has written in support of the idea. So do Grover Norquist (President of Americans for Tax Reform), Senator Ted Cruz, and House Ways and Means chairman Kevin Brady. Rep. Devin Nunes of California has introduced a bill in the House to implement it. Should Congress prove unable to pass the measure, Treasury Secretary Mnuchin’s department is exploring whether it could introduce the tax change administratively.
Many taxes — for example, income taxes — are already indexed for inflation. So are many benefits — such as social security. If inflation indexing hadn’t been introduced for income taxes, inflation would produce bracket creep — individuals or couples thrown into progressively higher tax brackets through inflation. But capital gains anomalously were never thus indexed. As a result, when individuals or companies sell an asset, especially one held long term, they can end up paying taxes when the asset sale produces a nominal gain in income but no real gain or even a real loss in purchasing power — because of inflation between the asset’s purchase and sale.
The unfairness of unindexed capital-gains taxes produces many side effects that hurt economic growth. Large amounts of capital are tied up in less productive assets to avoid incurring the taxing of non-existent gains. That capital would otherwise go to more productive investments such as new businesses and startups, many of which are starved for capital. Unindexed capital gains taxes also hurt seniors, who often need to sell assets to finance their retirement. Not only are they denied the real purchasing power their long-term investments should have brought them, but the nominal income from the asset sale will often kick them into a higher income tax bracket.
Democratic opposition
The reason such a sensible measure wasn’t passed a long time ago is that whenever it is broached by Republicans, most Democrat politicians and their press all scream in unison how Republicans are giving another benefit to the rich. They are oblivious to the damage their economic illiteracy causes to growth, productivity, and employment.
Some Democratic economists, such as Princeton’s Alan Blinder, know better. In an opinion editorial in the Wall Street Journal, Dr. Blinder stated that he was for indexing of capital gains, as long as interest deductions and depreciation were also indexed. Fair enough. His other caveat was that he wanted taxes raised elsewhere to make up for what he claimed would be the tax loss from indexing. There are two problems with this stipulation, however. First, it’s not at all self evident that there would be a tax loss from indexing capital gains. Historically, when capital gains taxes have gone down, tax revenues have shot up because more assets are sold when tax rates are lowered. Secondly, Democrats, including Dr. Blinder, seem always to want to address deficits with more taxes. But what about the textbook conservative / libertarian suggestion: reduce spending!
The big “but”
Desirable as the indexing of capital gains would be, it doesn’t address another severe flaw in the US tax system — the double taxation of dividends — and the harmful effect this has on entrepreneurship, startups, and productive investment in general. The best way to address this severe flaw would be to do away with the taxation of dividends and interest at the individual income level (the destination) and instead tax the income once only at the business level (the source). This would encourage increased saving, which in turn would provide the funds for increased investments. This proposal is one aspect of the justly famous Hall-Rabushka flat tax proposal.
In the meanwhile, indexing capital gains will provide some relief until, we hope, a more fundamental reform can be undertaken.
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