Trump’s Capital Gains Taxation Idea Could Have a Surprising Victim

(Bloomberg Businessweek) -- President Trump thinks capital gains should be indexed to inflation so people pay taxes only on their real profits, not the phantom part that comes from inflation. This makes sense: If your asset rises in price 5% between purchase and sale but the general price level also went up 5% during the time you owned it, you haven’t made a real capital gain, so why should you pay a capital gains tax?

The obvious flaw in the Trump fix is that indexing capital gains for inflation would be a windfall for the richest of the rich. According to the Tax Policy Center, the 1 percent wealthiest households received 69% of taxable long-term capital gains in 2018. Trump has acknowledged that problem in the past, saying a year ago that indexing is “perceived as somewhat elitist.”

There are other problems, like the paperwork mess of having to take the Consumer Price Index into account when you calculate the cost basis of investments that you sell. But the biggie is the fairness one. Capital gains are already taxed more lightly than wages, and indexation would make the disparity greater.

There is a way to get rid of the unfairness of the tax on phantom inflation profits without creating a new unfairness of skewing the tax burden toward the less-wealthy. That would be to raise the rate on capital gains taxation just enough (or even more than enough) to offset the revenue loss from indexation. That would require congressional action, as opposed to indexation alone, which Trump might be able to do by executive order.

Eugene Steuerle, an Institute fellow of the Urban Institute, looked at the effects of such a change in a 2018 article for the Brookings-Urban Tax Policy Center. One surprising finding: It could hurt hedge funds, assuming that hedge funds earn higher returns from their investments than ordinary investors.

Here’s why: Let’s say the dumb money (you and I) earn 4% on our investment and the hedge fund earns 10%. Inflation is 3%. So you and I had a real return of 1% and the hedge fund had a real return of 7%. But since we’re all being taxed on our total return, not just the real portion, the effective tax on the real portion is much higher for us than it is for the hedge fund.

In Steuerle’s hypothetical system, everyone would be taxed on the real portion of their returns, but the capital gains tax rate would be higher. Writes Steuerle: “Such a reform could redistribute the tax break to investors who tended to get lower returns over time from those who through luck or skill were big winners.” Such as hedge funds.

Not such a bad idea, all things considered.

©2020 Bloomberg L.P.