More than two dozen conservative groups renewed their effort to get the White House to index capital gains to inflation by executive fiat, but doing so would raise both legal and practical questions.
“We write to strongly recommend that you use your executive power as president to end the tax injustice that is currently included in the computation of capital gains,” the groups wrote in a January 29 letter to President Trump and Treasury Secretary Steven Mnuchin. Signatories include conservative heavyweights like the Club for Growth, Americans for Prosperity, and Heritage Action.
Without inflation adjustments, taxpayers’ capital gains are “eaten away,” yet they’re still forced to pay taxes on the “phantom income,” the groups argue.
Such a proposal may have some traction with the Trump administration. In an August 11, 2017, op-ed in the National Review by Larry Kudlow and James Carter, two of Trump’s former economic advisers, the pair said Congress never actually mandated that the capital gains cost basis had to be determined in nominal terms, and Treasury has the regulatory authority to interpret the word “cost” as it sees fit.
Neither the White House nor Treasury responded to Tax Analysts’ request for comment.
The possibility of indexing capital gains to inflation through executive authority was previously explored by the George H. W. Bush administration, but a September 1992 memoby the Justice Department’s Office of Legal Counsel concluded that there was no such authority.
However, both Kudlow and Carter noted that a 2012 paper by Charles J. Cooper and Vincent Colatriano in the Harvard Journal of Law & Public Policy concluded that Treasury’s authority has evolved since 1992, and it now has more clear-cut regulatory authority to index capital gains to inflation.
That view was shared by Steven M. Rosenthal of the Urban-Brookings Tax Policy Center (TPC), who told Tax Analysts there’s “been some shifting of thought, both as a legal matter and as a practical matter.”
Treasury “probably has a lot of latitude” in defining cost basis to reflect inflation adjustments, said Rosenthal. “The term ‘cost basis’ has been around forever, but the fact that the term has been around forever does not prevent the government from issuing guidance,” he said.
However, Edward D. Kleinbard, former chief of staff of the Joint Committee on Taxation, contended that indexing capital gains “goes far beyond any rational construction of Treasury’s scope of regulatory authority.”
Kleinbard, now at the University of Southern California Gould School of Law, also said that to argue otherwise would be ironic, given that many of the conservatives who opposed President Obama’s anti-inversion regulations for executive overreach are “the same people arguing for extraordinary authority here.”
The letter says indexing capital gains to inflation would produce “an immediate, pro-growth effect” on the economy, boosting the after-tax rate of return on stocks and “thereby increasing the wealth held by the millions of working and retired Americans who own 401ks, IRAs, mutual funds, and brokerage accounts.”
A 2013 report by the Tax Foundation also criticized the current capital gains treatment as taxing capital gain both on the increase in the taxpayer’s income and on increases in prices across the economy, thus increasing the top effective capital gains tax rate from 23.8 percent to an average of 42 percent over the years since 1950.
According to that report, the best solution would be to repeal the capital gains tax altogether. While acknowledging that that solution may be “politically impractical,” the report said indexing capital gains basis to inflation would be the next best solution, and would “not be so different from the inflation factor the IRS determines annually for calculating the increase in brackets, thresholds, and deductions for the personal income tax.”
Not all agree that such a switch would be so simple. “There’s some theoretical basis for it, but there are some practical difficulties,” said Eric Toder, co-director of the TPC.
Toder said it raises the question of how far do you go in applying the inflation adjustment. Although it might seem fairer to apply an inflation adjustment on capital gains, Toder said that it would also then need to apply to debt.
“People have a concern that if you only partially index the system, then you’re gonna cause arbitrage among assets. People are going to want to switch from bonds to equities and with no change in their income, they get a reduction in their tax liability,” Toder said.
Likewise, Rosenthal said that even though he was fairly confident Treasury has the authority to adjust capital gains cost basis for inflation, he emphasized that to actually do so “is one of the dumbest ideas one could tackle . . . because it just adds a huge amount of complexity.”
Rosenthal recalled an experience from his time as legislative counsel for the JCT in the early 1990s, when the staff was directed to draft legislative language and wrestled with the questions Toder raised. “We went off and drafted for a couple of weeks, and there was a complete, ungodly mess. Because you have to index on both sides of the balance sheet, both the asset and the liability side,” he said, adding, that it was a “mindbender” trying to figure out how to index a liability.
Kleinbard also argued that “the deferral afforded by our realization-based tax system means that the effective tax rate on capital gains goes down the longer the holding period,” and that all taxpayers are affected by inflation through other means, like increases in wages due to higher costs of living.
“In reality the capital gains indexing proponents are asking for a double discount in the tax rate imposed on this one form of capital income," he said.
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