Tax Reform 2.0: Indexing Capital Gains

Indexing capital gains for inflation has long occupied a place on many conservatives’ wish lists. A recent push suggests it may be closer to becoming reality than it has been for decades.

While many Americans consider tax reform to be a done deal, there may be more changes coming. Conservative lobbyists and lawmakers have been debating whether the administration should implement indexing, effectively an additional tax cut, on its own or leave the matter to Congress. A recent opinion column in The Wall Street Journal urged President Trump to take action, while an opinion column in Bloomberg in March insisted the policy needed legislative backing. Both sides of this debate ultimately support the same policy, however, which would build in an allowance for inflation’s effects on an asset when determining how to tax it.

When you sell an asset, such as a stock, you typically report the selling price and how much you bought the asset for originally (your “basis”) on your tax return. The difference between the two amounts is the capital gain, which the government taxes at the long-term capital gains rate, as long as you have held the asset for at least a year.

If you’ve held an investment for many years, however, the basis may no longer be close to what you actually paid in present-day dollars. Ryan Ellis, a Forbes contributor, gave the following example: “$100 in 1990 is only worth $51.41 today, a little more than half the supposed basis in real terms. If you were instead allowed to index the $100 basis to inflation, it would be worth $194.52 today, nearly double the nominal purchase price.” Based on this, if you sold the stock for $300 in today’s dollars, under the current rules you would owe tax on a $200 gain – the sale price less the $100 in basis. If the basis had been indexed, however, you would owe tax on $105.48 instead, cutting tax almost in half. Under these circumstances, the tax would reflect the real gain in value, and not “phantom” appreciation due to inflation alone.

Indexing capital gains makes some sense in theory, but that does not necessarily mean it is a good idea in the real world. At first, my reaction to the prospect was purely negative. First of all, the idea struck me as nearly impossible to implement. How many investors want to keep track of the effects of inflation on a variety of assets’ basis over decades, or even have the ability to do so? Second, it also seemed to me that the policy would mainly benefit those who did not need much of a leg up in our financial system.

The more I thought about it, however, the more it seemed to me that there would be a workable way to deal with both of these problems.

While it is true that individual investors would find it burdensome at best to calculate cost basis with inflation factored in, there is no reason they should have to. Investment brokerage firms, by law, must track and report cost basis already. Brokerages may not like the idea of having to set up new systems to adjust cost basis for inflation, but that doesn’t mean it would be impossible. For instance, the brokerage could simply increase assets’ cost basis every month or every year by changes in the Consumer Price Index. If the government required brokerages to track inflation-adjusted basis automatically, it would make transactions and tax reporting straightforward for investors under most circumstances. Unlike individuals, brokerages should have the resources and economies of scale to make such calculations practical.

Some brokerage firms might even voluntarily jump on board in the absence of regulatory pressure. Indexing capital gains could lead to an increase in trading – and thus commissions – because investors who had been reluctant to sell long-held assets would no longer effectively face a penalty for inflation’s impact on capital gains. My guess is that indexing capital gains would trigger an initial wave of trades, and would likely increase the average rate of trading going forward because of the reduced tax burden for investors.

As for the lopsided benefits, it is true that the proposed changes to the capital gains tax system would mainly benefit high-income taxpayers. But if the goal is truly to make a fairer tax system, Congress could take the opportunity to offset any reduced tax revenues by changing other existing rules that disproportionately benefit the wealthiest taxpayers, making the overall effect revenue neutral. For example, here are a few changes that could partially or fully offset the impact of indexing capital gains for inflation:

Keep fighting the carried interest loophole. Carried interest describes a longstanding tax break for private equity and hedge fund managers, allowing them to pay the lower capital gains rate on a large portion of their income. The Tax Cuts and Jobs Act of 2017 targeted this rule in part by requiring fund managers to hold investments for at least three years in order to be eligible for this rate. The minimum holding period could be further increased, or new legislation could be drafted to try and outlaw carried interest tax benefits altogether.

Further reduce the mortgage interest deduction. The Tax Cuts and Jobs Act reduced the mortgage balance on which interest can be deducted from $1 million to $750,000. But what if lawmakers tied the ceiling to the loan limits published by the Federal Housing Finance Agency, which governs mortgages delivered to Fannie Mae and Freddie Mac? For 2018, this would make the threshold $453,100 in most of the country. Low-income taxpayers generally don’t take out $750,000 mortgages, so there should be room to cut this deduction, politically unpopular as such a move might be.

Increase ordinary or capital gain rates. Congress could take direct action to offset indexing capital gains, such as raising the top marginal tax rate on ordinary income or capital gains by 1 or 2 percent. While most politicians with good survival instincts want nothing to do with a tax increase, this could be explained simply as a revenue neutral maneuver. Maybe I’m giving taxpayers too much credit, but I think the average citizen could understand and agree with a move like this.

Would there be unintended consequences to indexing capital gains for inflation? Sure. The policy could open up all kinds of new strategies for tax planning, as well as distortions and oddities in investment markets, especially over the short term. But it is also something we would probably get used to quickly. I’d expect its total impact on tax revenues and investor behavior to be relatively small.

Indexing capital gains in a revenue-neutral manner would allow lawmakers to incentivize investment while also demonstrating fiscal responsibility. If the goal truly is to make our tax system fairer for everyone, indexing capital gains may very well be in our future.

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