Indexing Capital Gains

Tax reform is a largely unfinished piece of work. Granted that President Donald Trump managed to steer a do-nothing Congress into reducing rates for all taxpayers and to simplify filing tax returns for many by increasing the standard deduction in lieu of the painstaking task of itemizing. The net result has been the predictable surge in the economy with the predictable increase in tax revenue.

Those of you who were forced to endure a teachers union led education in the Portland Public School have been taught that the only way to increase revenue from taxes is to raise tax rates. Like so many other things that the teachers unions have peddled to our nations youth, they are decidedly wrong. You can raise tax revenue by increasing the base upon which taxes are paid and one of the best ways to do that – particularly following an anemic economy managed by former President Barack Obama – is to reduce taxes in a fashion that puts more business and discretionary spending back in the hands of those responsible for producing economic growth – the taxpayers.

Former Presidents John F. Kennedy (D) and Ronald Reagan (R) demonstrated that phenomena during their presidential terms and former President George W. Bush did so on a lesser degree during his presidency. It is often referred to as the Laffer Curve based on a theory postulated by economist Dr. Arthur Laffer relating to taxable income elasticity. In its simplest form it means that increases in taxable income lag increases in the tax rate – and the reverse is equally true that decreases in tax rates result is a larger growth in taxable income. It is a concept that drives liberal/progressives crazy and they go to great lengths to deny its cause and effect – in effect denying reality.

It is obvious that the Congress is incapable of addressing a total tax reform package for fear of losing campaign support from those who benefit by the complexities of the current tax code. Therefore, reform must proceed in smaller bites. And one of those bites can be found through indexing long term capital gains.

Taxes on long-term capital gains do not constitute a significant percentage of tax revenue. According to an article by Cam Merritt in the June 29, 2018 edition of Pocket Sense:

“As a share of total federal revenue from all sources, capital gains taxes averaged about 4.2 percent from 1995 through 2009. That ranged from a high of 5.9 percent in 2000 to a low of 2.8 percent in 2003.”

Thus addressing changes in taxing capital gains will effect only a small portion of government’s revenue stream.

Capital gains are amongst the most elastic of all the categories of taxes. Thus holders of these capital assets easily make decisions as to when to trigger the gain (when to sell the asset).

A study by the Treasury Department on taxes paid on capital gains from 1980 through 2014 demonstrates as the tax rate fell from about 28 percent to 15 percent the base of realized long term capital gains grew at a faster rate thus producing a larger amount of revenue from the capital gains tax. The reverse was also true when rates jumped up as in 2013 and realized capital gains dropped by about one-third.

In a Wall Street Journal article by Mark Bloomfield and Oscar Pollock, dated April 20, 2017 the authors presented the challenge in reducing capital gains taxes:

“We began working on this issue in 1977 and have observed the long-term consequences of changes in the capital-gains tax. This particular levy is unique in that most of the time the taxpayer decides when to “realize” his capital gain and, consequently, when the government gets its revenue. If the capital-gains tax is too high, investors tend to hold on to assets to avoid being taxed. As a result, no revenue flows to the Treasury. If the tax is low enough, investors have an incentive to sell assets and realize capital gains. Both the investors and the government benefit.”

The authors provided further detail on the effect of raising and lowering the long-term capital gains tax rate:

“Many have offered opinions on which maximum tax rate would raise the most revenues. Our experience suggests the ideal federal capital-gains tax rate is 15%.

“The chance to test that theory came in May 2003, when Congress lowered the top rate on long-term capital gains to 15% from 20%. According to the Congressional Budget Office, by 2005-06 realizations of capital gains had more than doubled—up 151%—from the levels for 2002-03. Capital-gains tax receipts in 2005-06, at an average of $98 billion a year, were up 81% from 2002-03. Tax receipts reached a new peak of $127 billion in 2007 with the maximum rate still at 15%. By comparison, federal capital-gains tax receipts were a mere $7.9 billion in 1977 (the equivalent of about $31 billion in 2017 dollars), according the Treasury Department. The effective maximum federal capital-gains tax was then 49%.

“The vociferous critics, who denounced us for trying to “unsoak the rich” over the years, should instead thank us for finding a way to make the wealthy pay much more in taxes.

“Now fast-forward to the recent past. Congress raised the top capital-gains tax rate back to 20% in 2009 and later added a 3.8% tax on investment income, including capital gains, to help pay for the Affordable Care Act. The top federal rate is now 23.8%.

“In 2009 through 2012, capital-gains realizations and tax receipts came in sharply under those of the previous four years, but one cannot blame all that on the higher tax rates. The recession and subsequent stock and real estate market declines were no doubt big factors. Tax receipts have enjoyed a recovery during the past few years.

“Yet realizations of capital gains from 2013-16 remained considerably below prior peaks despite improvement in the economy. The subdued level of realizations is evidence of a considerable lock-in effect caused by higher rates.”

All of which brings us back to the issue of indexing capital gains. Indexing is a process utilized throughout government programs – including tax programs – to adjust for inflation. The purpose of indexing is to adjust values to a constant dollar amount. So an item that cost $1,000 in 2003 at the end of 2017 cost $1332.50. It’s the same item it just cost more to acquire it in 2017. Had you sold the item in 2003 you could have purchased a basket of goods for $1000. That same basket of goods will now cost you $1332.50. In other words your wealth has not changed. However, if you do sell your asset you will be subject to a fifteen percent tax on the gain (not counting what a state will levy) which leaves you with only $1132.60 to buy that basket of goods. In other words you have actually lost ground solely because the government has elected to tax a gain that really doesn’t exist.

The solution to that inequity is to index the base (original amount) of the capital asset and then tax only the amount by which the actual sales price exceeds the indexed asset value. In the above example if you sold the item for $1500 you would index the base from $1000 to $1332.50 and subtract that from the sales price ($1500) giving you an actually realized gain of $167.50 upon which the capital gains tax would be levied.

There is simply no reason why the government should profit from the effects of inflation and every reason to hold taxpayers harmless from the effects of inflation. It is the same reasoning as applied to indexing tax brackets to avoid bracket creep due to inflation. Indexing tax brackets has been in effect since 1985 at the behest of President Ronald Reagan. An article by Stephen Entin in the March 11, 2015, of the Tax Foundation publication noted:

“As you prepare your 2014 taxes, you may notice that the 2014 personal exemptions and standard deductions are higher than for 2013 filings. So are the dollar amounts that separate each tax rate bracket from the next highest. These amounts are adjusted upward each year for inflation, in a procedure called ‘tax indexing.’ Tax indexing turns 30 this year.”

“Tax indexing was enacted in the Economic Recovery Tax Act of 1981, and took effect for tax years 1985 and beyond, following three years of tax rate reduction. President Reagan highlighted the indexing feature of the tax plan in his address to the nation before the critical House vote on the bill. He explained that without the indexing, inflation would continue to force people into higher tax brackets, and would effectively repeal the tax cuts. With indexing, he could promise to get people’s taxes down and keep them down.”

I would limit the indexing to tangible capital assets held for more than two years so as to avoid applying it to speculating. But that’s it. The effect will be precisely the same as noted in the above in the Bloomfield/Pollock article:

“If the capital-gains tax is too high, investors tend to hold on to assets to avoid being taxed. As a result, no revenue flows to the Treasury. If the tax is low enough, investors have an incentive to sell assets and realize capital gains. Both the investors and the government benefit.”

By mitigating the reason to defer a decision on selling a capital asset the likelihood of the sale is greater and the production of taxable gain is regular.

Of course all of this will have to happen at a federal level first because the Democrats-in-charge in Oregon won’t understand a thing that is said in this article.