Congress Being Pushed to Index Capital Gains Taxes for Inflation

Published February 1, 2007

Just weeks before the Congressional recess, momentum was building in Congress to change the method for calculating capital gains taxes, by adjusting investors’ gains for inflation. Indexing, as the process is called, ensures taxpayers pay taxes only on real gains, instead of on increases caused by inflation. Another push for indexing is expected this year.

Sandra Fabry of Americans for Tax Reform recently interviewed Daniel Clifton, executive director of the American Shareholders Association in Washington, DC, on the subject of capital gains tax indexing.

Fabry: The notion of indexing the capital gains tax for inflation really caught fire in September. How did this come about?

Clifton: It’s an old idea that stems back to the late 1980s, early 1990s. The idea was conceived when research showed that over long periods of time inflation was eroding investor gains. A 1993 presentation by then-Federal Reserve Board governor Wayne Angell calculated that the average real tax rates on investments from 1972 to 1992 in NASDAQ stocks was 68 percent, 101 percent in the S&P 500, 123 percent in the New York Stock Exchange, and 233 percent in the Dow Jones Industrials.

So on three of the four major indexes, the average capital gains taxes were higher than the real return.

Inflation was eroding any of the real gains for shareholders, and indexing was the way to end that.

The issue completely fell off the radar screen during the mid-1990s as the rapid stock market gains, combined with low inflation, minimized the need for indexing. But I saw inflation heating up again and started pushing the issue in June.

Fortunately, Reps. Michael Pence [R-IN] and Eric Cantor [R-VA] noticed the same effect and introduced legislation, H.R. 6057, in late August to start the conversation. Not only did the conversation start, 85 members of Congress signed up to co-sponsor the legislation in two weeks. This was unprecedented, given the fact that the legislation had not been around in years and a totally new education process had to begin.

The rapid support for the legislation is a very healthy sign that members of Congress understand middle-class families own shares of stock and smaller accounts are most affected by inflation.

Fabry: How would the legislation work?

Clifton: Let me start with a simple example. Under current rules, an investor who purchased a stock for $10 a share in 1952, and sold it for $20 a share in 2002, would be forced to pay capital gains taxes on the gain from $10 to $20. However, due to inflation, the real value of that investment is only $3.44 in 2002, a 66 percent loss.

The investor lost money and still had to pay $1.50 tax on the inflationary “gain.”

H.R. 6057 would change the basis for calculating the capital gains tax by adjusting the gain for inflation. In the investor example I just mentioned, the change from $10 to $20 would in real terms actually be a loss, so no capital gains taxes would be owed.

My research indicates about 18 to 20 percent of all increases in shareholder wealth are the result of inflation. This legislation would eliminate the tax on that 18 to 20 percent. This would allow shareholders to produce larger compound gains and create wealth.

Fabry: What effect would an 18 to 20 percent reduction have on economic growth and wealth creation?

Clifton: The large reduction would have a significant impact on growth. Take, for example, the 2003 capital gains tax reduction. That was a 25 percent reduction, and in three years $13 trillion of new household wealth was created. A similar effect occurred following the 1997 capital gains tax reduction.

While the change sought by Reps. Pence and Cantor does not constitute a change in tax rates, it would still amount to a 20 percent reduction in taxes owed and increase shareholder and household wealth substantially.

At the same time, uncertainty in long-term investment would become less risky. Currently, a venture capitalist has to factor in inflation on top of the tax rate when making long-term investment decisions. This holds back investment. By eliminating inflation as an investment risk, we reduce that uncertainty, which will spur investment and create jobs.

Fabry: What are the prospects for passage?

Clifton: I feel confident something will be done because it is a very simple message: Are you for tax inflation or not? Most policymakers on both sides of aisle see how ridiculous the current structure is and will work to end this unjust tax.

There are two roads that can be taken.

The first road is to build support in Congress. Although the Democrats have taken over and are less likely to move this legislation, if enough members sign up for the effort we can exert pressure legislatively.

The second road is related. Legal opinions suggest that President Bush could issue an executive order by changing the basis for inflation. In 1913, the Treasury Department factored nominal [i.e. non-inflation adjusted] gains. If they had the authority then, they have the authority now. A legal opinion by former Reagan Justice Department official Charles Cooper did in fact conclude this to be the case.

It is my hope that the president will issue the executive order to finally end this onerous inflation tax. If the president sees enough support in Congress, he may do so.

Either way, I am hopeful.

Sandra Fabry ([email protected]) is state government affairs managers for Americans for Tax Reform.