Leave the capital gains tax alone

Leave the capital gains tax alone
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The Trump administration is considering changing the capital gains tax rules to adjust for inflation. Although the idea seems sensible at first glance, its appeal fades under closer scrutiny. Making the change without the approval of Congress might be illegal and would certainly be undemocratic. Even with legislative approval, an inflation adjustment for capital gains, but not interest payments, would be seriously flawed.

This is how the proposed inflation adjustment would work. A person who sells a capital asset is taxed on any gain from the sale. Under current rules, the gain is the amount for which the asset is sold minus the amount paid to buy it. For example, someone who bought shares of stock 10 years ago for $100 and sells the shares today for $120 must pay tax on the $20 gain. Taking inflation into account, however, reveals that $100 spent to buy the stock had the same buying power 10 years ago as $113 has today. Based on the buying power of the sales proceeds and the purchase cost, the seller is actually only $7 ahead. The proposal would let the seller deduct the adjusted $113 cost, so that only $7 would be taxed.

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At first glance, the idea seems reasonable. Why should anyone have to pay tax on imaginary gains that are canceled out by inflation? But things are not that simple. One problem is the way the change would be made. Rather than asking Congress to change the law, the idea is to have the Treasury Department issue a regulation defining the term “cost” in the federal tax laws to mean inflation cost rather than dollar cost.

Unilateral action by the Treasury Department might be an illegal infringement of the lawmaking power of Congress. Although the Treasury Department is authorized to spell out definitions for ambiguous terms in the tax laws, it is not clear that “cost” is ambiguous in this context. Some legal scholars have argued that the Treasury Department has the power to adopt the inflation definition, but others have disagreed, including the office of legal counsel under the George H.W. Bush administration.

Even if the Treasury Department has the legal authority, it would be undemocratic for anyone other than the American people, through their elected representatives in Congress, to make such a major policy change. Congress has given capital gains a special 20 percent top tax rate, well below the 37 percent top tax rate on most types of income, partly because some of the gains subject to tax are canceled out by inflation.

Shielding inflationary gains while leaving the special tax rate, which the Treasury Department cannot change, in place would upset the delicate balance struck by lawmakers. When Congress enacted the most sweeping tax law in three decades last year, it left capital gains tax rates essentially unchanged. The Treasury Department should not override that decision by granting its own capital gains tax cut, especially one that, depending on the details, could be worth $100 billion to investors over 10 years.

Any inflation adjustment should be adopted by Congress. Indeed, there are bills pending in both the House and the Senate. Unfortunately, the bills share a major flaw of the potential regulation, which is that they would apply the adjustment to capital gains but not interest payments. If a lender charges 3 percent interest when inflation is running at 1 percent, the lender comes out ahead only 2 percent, and the borrower is out of pocket only 2 percent in real buying power. Yet, the lender pays tax on the full 3 percent and, if the payments qualify as business, investment, or mortgage interest, the borrower deducts the full 3 percent.

There is no justification for granting an inflation adjustment to capital gains while denying it to interest income, which is already taxed more heavily. Interest income does not receive the special 20 percent tax rate, and interest income is taxed every year while capital gains are not taxed until the asset is sold. Any adjustment should also apply to interest expense. Otherwise, investors could set up tax shelters in which they deducted their full investment interest expense while paying tax on only the portion of their capital gains adjusted for inflation.

A comprehensive inflation adjustment that includes interest payments might be worth considering, although the complexity of carrying out this policy would probably outweigh the modest benefits it would offer given the low inflation rates today. In any event, the Trump administration should not adopt a piecemeal inflation adjustment that applies only to capital gains, and the Treasury Department should not change important tax policies without legislative approval from Congress.

Alan D. Viard is a resident scholar at the American Enterprise Institute, where he studies federal tax and budget policy. He previously served as an economist at the Federal Reserve Bank of Dallas, the White House Council of Economic Advisers and the United States Joint Committee on Taxation.