The Only Fair Way to Index Capital Gains for Inflation

(Bloomberg Opinion) -- After the Trump administration floated a proposal to index capital gains taxes for inflation, it was hard to spin it as anything less than a gift to the super rich. Little wonder: Two-thirds of the savings from such a move would go to the top one-tenth of 1 percent of U.S. taxpayers. The public reaction was overwhelmingly negative. 

Former Trump economic adviser Gary Cohn declared the idea dead on arrival, and the administration has given little real indication it’s pursuing the idea further. That’s likely for the best, but we perhaps shouldn’t let it go so quickly. Trump’s proposal highlights one of the deeper problems in the tax code. Congress should fix it.

The problem, in short, is that inflation does not factor consistently across the entire tax code. Some parts of the tax code get adjusted to reflect inflationary pressures: the standard deduction on Form 1040, for example, the earned-income credit and other variables that evolve from year to year, depending on changes in prices. Many of these index provisions date back to the Economic Recovery Tax Act of 1981.

But long-term capital gains have always been another matter. The first modern capital gains tax dates to 1913, though it wasn’t until 1918 that the tax code defined capital gains as the “gain from the sale or other disposition of property [in] excess of the amount realized therefrom over the adjusted basis.” That key word “basis” was defined as “the cost of such property.” 

Left undefined, however, was “cost.” If cost meant the nominal price paid for the asset when first purchased, then the profit realized would necessarily reflect whatever increase in price inflation had caused between the time the asset was purchased and when it was sold. If inflation rose sharply, then investors would be hit with capital gains on inflation masquerading as profit.

This didn’t pose a problem at first: Few people actually paid capital gains taxes, and the inflation rate wasn’t particularly onerous, even if it did spike briefly at the end of World War I. As a consequence, there wasn’t a whole lot of concern that capital gains taxes didn’t correct for the effects of inflation. The coming of the Great Depression, when deflation became a serious problem, deflected attention away from the issue.

In the immediate postwar era, though, a handful of observers began to question the wisdom of calculating capital gains taxes without correcting for inflation. In 1946, the New York Times described this phenomenon as “a tax upon a phantom profit,” and argued that the capital gains tax should be repealed entirely, given the inequities it imposed.

In 1951, the National Bureau of Economic Research examined the problem as part of a much larger study of the capital gains tax system. The report’s authors conceded that “to the extent that capital gains and losses are offset by an opposite change in the purchasing power of money, they are doubtless fictitious in the sense that they do not measure a change in the economic status of the recipient.”

The report suggested that under exceptional circumstances, when inflation rages unchecked, “special measures may well be warranted to exclude the illusory capital gains from income taxes.”

But gradual changes in the price level could be dealt with in other ways. The report’s authors noted that the U.S. had coped with the problem “by according a preferential tax treatment to all capital gains and imposing restrictions on the deductibility of all capital losses.”

This became the standard way to address the dilemma in the postwar era: Tax capital gains, even if some of them could be ascribed to inflation, but keep the capital gains tax rate below the rate on ordinary income and wages. 

This was an exceedingly crude way to correct for the effects of inflation, but it became the default method for politicians and policymakers from this point forward. In 1957, the Treasury Department finally defined “cost” to mean the nominal price initially paid for assets, effectively formalizing this arrangement.

This approach worked well enough as long as inflation remained tolerably low, but by the late 1960s and early 1970s, the arrangement broke down. In 1969, the economics commentator Henry Hazlitt wrote in the Los Angeles Times: “Under past and present prospective inflation, the present capital-gains tax amounts to a large extent to capital confiscation.” He recommended that taxpayers selling assets be permitted to deflate their nominal gains by indexing them to inflation.

These calls grew louder the following decade as inflation reached double digits. At the very same time, academic studies demonstrated that many taxpayers ended up paying significant capital gains taxes even when they actually sustained a real (inflation-adjusted) loss on the sale of some asset. To make matters worse, capital gains taxes actually increased during this period, eroding their preferential treatment.

In response, Congress floated numerous proposals to index capital gains to inflation. None became law, but after Ronald Reagan’s election in 1980, two things happened that helped restore the balance: Inflation went back to manageable levels, and Congress cut the capital gains rate. The issue then came back into view in the late 1980s and early 1990s, when the capital gains rate all but lost its preferential treatment vis-a-vis income tax rates.

Congress repeatedly contemplated indexing capital gains to inflation, but consistently returned to its earlier approach in dealing with the problem: restoring some preferential treatment to capital gains while leaving the problem of inflation unaddressed. This has never been a particularly elegant solution.

But indexing capital gains without changing their preferential treatment in the tax code only makes the situation worse. This is what the Trump administration contemplated last week, and it’s hard to view it as anything but a giveaway to the wealthiest investors, particularly in an era of low, though not insignificant, inflation.

The solution to this impasse lies with Congress, which should finally change the tax code to index capital gains to inflation. But if it goes that route, it should simultaneously end the preferential treatment given to capital gains within the larger tax code. Doing so would finally put an end to what has always been a simplistic solution to a complicated problem.

To contact the editor responsible for this story: Katy Roberts at kroberts29@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to Bloomberg Opinion.

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