A Contrarian Dialogue

Eber Views

Don't stop the axe

Music Ethics Be Damned

Index Capital Gains

A Most Egregious Pronouncement

Cocksure Public Spenders

Balanced Budget Busting

Why We Need To Index Capital Gains First

We are hearing that the new budget deal will include long-awaited capital gains tax reductions. Rep. Bill Archer of the Ways and Means committee has been suggesting some combination of indexing gains to inflation and minor rate reductions. Assuming that these are the only politically feasible choices, there are a number of reasons why the budget cuts should be first applied to full indexing, then any remaining balance to tax rate reductions:

Long term investors have stabilized the market. Those who have socked their savings away in capital investments for the long term can be credited with the capital formation that has spurred this economy’s growth over the last decades. Why should their prudent savings be taken from them by taxing gains due to inflation? Some might argue that the capital gains tax has created stability by preventing frequent movement of capital. But how much better would the market have done if gains could be moved freely to more productive investments, timed against the market instead of the tax?

It would unlock pent-up assets for new productive uses. How much of this capital is now stuck in unproductive use just to avoid the tax? Assets are locked into low performing investments because of capital gains taxes. How much more would the economy benefit if the capital were to be released for more productive use? Investors wait for their best deal, and, anticipating favorable tax rate reductions, may wait too long, further distorting the market. People may hold investments beyond product life cycles for which their investment originally looked favorable, and into cycle downturns, just to avoid the tax. Over the last twenty years, capital gains rates have gone up, then down, and then up. Now, they may possibly go down again. While investors attempt to make timing decisions, inflation also eats away at their rate of return. Why should these losses to inflation be taxed as gains?

Some might argue that the market has already taken inflation into account and that yield requirements are already higher to offset the projected inflation rates. Such an idea would suggest that we knew how new legislation would tinker with the code, either long term or short term, or that the estimated cost of that risk of tinkering has been built in. For instance, the stock market has recently bounded ahead with talk of capital gains tax cuts. If changes in the tax rate do not come to pass, those who have bet on reductions may as well have been playing the horses. While the market is more visibly impacted by short term changes, or talk of changes, long term investors will simply hold and wait for the period of favorably low tax rates. Are the taxes on inflation built in to the market, or are they just an impediment to movement in the market that long term investors know must eventually be addressed?

It would match real dollars to decision-making. If someone has held a $20,000 investment for the last twenty years with a modest yield of 7.5%, it is now worth about $80,000. But the real basis is about $53,500, not $20,000. Tax on this sale would be 28% of $60,000, or 16,800, which would result in a real gain of only $9,700. Suddenly the yield is only a meager 2%. By changing the capital gains tax rate, legislators wield the power to directly alter the yield of this investment. If imminent changes reduce the capital gains rate to 20%, the real yield for this investment would be nearly 3%. The argument that the market will have built in this specific distortion is specious. Can anyone predict monetary policy or inflation even five years out? Why should investors, those who supply capital for the economy to flourish, be subject to this arbitrary uncertainty?

It would be fair. Various entitlement groups already demand that their benefits keep pace with inflation and have opposed any adjustment in the CPI calculation. While these groups receive automatic increases, another group, often demagogued as rich, must pay for those increases partly with taxes on inflationary gains, which are not gains at all. This inconsistency is indefensible, except as demagoguery.

But is it just the rich who benefit from capital gains tax reductions? Much evidence has been put forth to show that this is not the case. Ironically, many people fall into both groups.

If there is a continued insistence on having any capital gains tax at all, we must eliminate taxing gains due to inflation. Such a tax effects investors no differently than seniors on fixed incomes, whose purchasing power is diminished by inflation every year. It has been suggested that indexing would be generally too complex to calculate, but compared to the rest of the tax code, it would be a cinch. Other arguments against indexing fall into maintaining the status quo, or that wealthy investors can afford it. Where is the moral objection? Rep. Bill Archer has the opportunity before him to do what is best for free markets and vital capital formation.