The Congressional Research Service (CRS) has issued a report that analyzes various issues regarding modifying the taxation of capital gains so as not to tax gain attributable to inflation, including considering various methods of implementing such a modification and effects of such a modification on the amount of tax revenue collected and on economic activity.
Background. Capital gains reflect the change in value of an asset and are measured as the sale price minus the basis. Basis is generally the cost of acquiring the asset, but that cost is reduced by depreciation and increased by improvements in the case of assets such as buildings.
Assets yielding capital gains have a number of tax benefits that reduce their effective tax rates, including a lower rate, deferral of tax until gains are realized, and exclusion of gain at death.
But, in the taxation of capital gains, no direct consideration is given to the effects of inflation.
CRS considers effects of taking inflation into consideration. CRS has now issued a report considering various aspects of a tax system that considered the effects of inflation when taxing capital gains. The following are among the items discussed in the report.
… Specific proposals. President Trump’s head of the White House National Economic Council, Larry Kudlow, has long proposed the indexation of capital gains for inflation through regulation, and Americans for Tax Reform has urged Treasury Secretary Steven Mnuchin to index capital gains. Senators Ted Cruz and James Inhofe have introduced S. 2688, the Capital Gains Inflation Relief Act of 2018, which would index the basis of assets for purposes of the capital gains tax.
Past legislative proposals to index capital gains for inflation have never been enacted, although in some cases proposals led to alternatives such as exclusions or lower rates. In ’92, a proposal advanced to index capital gains for inflation by regulation was eventually rejected based on findings that the Department of the Treasury does not have the authority to index capital gains.
… Elements of laws taking inflation into consideration. The effects of capital gains indexing depend on a variety of features: the choice of the price index, assets covered (by type and holding period), whether indexing is allowed to generate or increase losses, whether indexing applies to past as well as future inflation, and whether indexing is in addition to or a substitute for current tax benefits.
… Economic effects. The analysis of various economic issues depends on whether indexing is in addition to or a substitute for current benefits.
As an additional provision, depending on the design, estimates suggest a range of $10 billion to $30 billion per year in revenue costs. Economic growth effects would be relatively small, with even the largest revenue estimate pointing to a decrease in the cost of capital of 6 to 7 basis points (lower required returns of 0.06% to 0.07%). Evidence also suggests that the savings effect would be small and likely to be offset by crowding out of private investment by government borrowing if the government’s loss of revenue was debt-financed. The change would favor high-income individuals, with about 60% benefiting the top 0.1% and around 90% benefiting the top 1% in the income distribution.
Favorable treatment for capital gains on stocks has been advanced due to the double taxation of dividends, but the significant lowering of corporate tax rates by the 2017 Tax Cuts and Jobs Act has made that justification less persuasive.
Capital gains indexing would reduce the distortion between debt and equity.
But, it would increase another distortion. Although qualified dividends and capital gains are taxed at the same rate, capital gains still benefit from being taxed only on realization or not taxed at all. The result leads to retaining too much income in the firm or using stock buy backs instead of dividend payments. Indexing capital gains for inflation would increase the motivation to retain, rather than pay out, earnings.
It would also reduce the lock-in effect that causes individuals to retain current assets because of the tax. And, administrative and compliance costs would increase because each vintage of assets would require a different exclusion.
References: For taxation of capital gains, see FTC 2d/FIN ¶ I-5101; United States Tax Reporter ¶ 14.08.
CRS Report, Indexing Capital Gain Taxes for Inflation, R45229 (June 18, 2018)
