Sunday, September 2, 2018

Capital Gains Indexing

I have seen reports that the President is considering changing the accounting of capital gains for tax purposes, adjusting the cost basis to reflect inflation. This would of course reduce the gain, and thus reduce the tax. Since almost all capital gains are earned by the very wealthy, and those taxes therefore paid by the very wealthy, this would be be a dramatic tax cut for the wealthy. These days the old maxim, the rich get richer, is as true as ever, so it would seem that such a tax cut is not at all appropriate.

However, it would be very simple, from an accounting perspective, to adjust for inflation in capital gains taxation in a revenue-neutral way. Of course, a change in tax accounting will change behavior, so precise revenue neutrality is too much to expect. But the resulting change in behavior should have great benefit to the economy and society. Short term capital gains are earned largely through speculation, taking advantage of price fluctuations. Long term capital gains are earned through investment, where the growth in underlying value is the primary determinant. This growth in underlying value is what benefits society. The tax code should encourage long term investment. Long term capital gains should be taxed at a lower rate than short term capital gains. This would be the effect of adjusting the basis to reflect inflation. Simply increasing the tax rate on capital gains could easily make the new accounting revenue neutral.

A parallel accounting adjustment would help the middle class. Interest earned should be corrected for inflation. When inflation is running at say 2% while bank savings accounts are paying 0.1%, perhaps the smart move would be to make the 1.9% loss a tax deduction. This would encourage savings and help middle class families build nest eggs.