Five Reasons Trump’s Trial Balloon on Capital Gains Taxation Should Sink

(Bloomberg Businessweek) -- Senior officials in the Trump administration are floating the idea that President Donald Trump could skirt Congress and cut taxes on his own. The goal is to adjust taxes on capital gains for inflation, which would reduce how much people have to pay the government. “Some believe Potus could do it as exec order,” National Economic Council Director Larry Kudlow wrote in an email to the Wall Street Journal in March. On July 30, the New York Times reported that Treasury Secretary Steven Mnuchin said in an interview earlier this month that “his department was studying whether it could use its regulatory powers to allow Americans to account for inflation in determining capital gains tax liabilities.”

There are legitimate reasons for concern that Trump and his people are overstepping. As long ago as 1992, the Treasury Dept. looked into the question for the administration of President George H.W. Bush and concluded that it lacked the authority to change the rules without Congress.

But even if Treasury's lawyers conclude in coming weeks that the executive branch is entitled to index capital gains to inflation without Congress's approval, that wouldn't make it a good idea. It's the substance of the proposal, not the means of promulgation, that's the real problem. In May, Syracuse University economist Len Burman gave five reasons for disliking the indexation proposal in a blog post for the Tax Policy Center, the Urban Institute-Brookings Institution project he co-founded in 2002.

Capital gains are, of course, the profits earned on investments. The tax on them is paid when the investment is sold. Right now if you buy something for $60 and sell it for $100, you pay tax on $40 in profit. Under indexation, you'd pay tax only on the portion of gains that exceeded inflation. So if cumulative inflation over the period raised the cost basis of the investment to $80, you would pay tax only on the difference between $100 and $80, namely $20.

Indexation sounds reasonable at first blush, but it's not. I'm going to take Burman's criticisms out of order because his last is the most significant, and it's easy to understand. The rich would win at the expense of everyone else. Indexing capital gains for inflation without simultaneously raising the tax rate would be “extremely regressive,” he writes. The vast majority of capital gains taxes are paid by the richest Americans. Eighty-six percent of the tax cut would go to the top 1 percent, according to the Penn Wharton Budget Model. Treasury could snatch back the windfall from the rich by raising the tax rate at the same time as permitting indexation, but it's not clear that would happen.

Second, if Treasury did adopt indexation, investors would likely rush to sell a lot of long-held assets to take advantage of the tax break before it went away. That would produce a surge in revenue for the government, making the budget deficit look smaller in the short run. In the long run, though, budget deficits would be bigger because of the lower tax rate. Revenues could fall $102 billion over 10 years, according to the Penn Wharton Budget Model. True, that's small compared with the overall deficit, which was swollen by the big Trump tax cut Congress passed in December. But as Burman quotes humorist Will Rogers, “When you find yourself in a hole, the first thing to do is stop digging.”

Third, capital gains are already taxed more lightly than other forms of capital income, such as interest, dividends, and rents, because all those types of income are taxed in the year the income is earned, while capital gains aren't taxed until the asset is sold. So singling them out for special treatment seems wrongheaded.

Fourth, Burman points out that the change would introduce a lot of complexity. As anyone who has paid a tax on capital gains knows, figuring out the cost basis can be complicated, and adding inflation into the mix would make it even worse. And fifth, Burman says, the change would spur the design of tax shelters that take advantage of the discrepancy between the tax treatment of capital gains and capital expenses, such as interest and depreciation. 

To contact the editor responsible for this story: Eric Gelman at egelman3@bloomberg.net

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