Bruce Bartlett, Guest Lecturer Jude Wanniski May 9, 1997

Supply-Side Economics Lesson No. 22

To: Website Students
From: Jude Wanniski
Re: Bruce Bartlett, Guest Lecturer

We had not planned on two guest lecturers in a row, but given the debate on the capital gains taxation in the budget deal between Congress and the President, the following discussion by Bruce Bartlett is most timely. In a visit to Washington last week, I'd run into Bruce and he told me about this paper, which is soon to be published by the National Center for Policy Analysis, at which he is a fellow. I asked to see it and as soon as it came in I read it and realized its importance. The paper reminds us that the most important economists of our time have been unanimous in arguing against the taxation of income that is inflated, not real. He also cites the reasons why Government goes right ahead anyway, citing another prestigious economist, Vito Tanzi. Mr. Bartlett, who was Rep. Jack Kemp's staff economist almost 20 years ago, is one of the original gang of supply-side revolutionaries. He worked at mid-level staff positions in both the Reagan and Bush administrations. An excellent and a prolific writer on political economics, his material shows up regularly on the NCPA website, which is one of my favorite bookmarks. [Try it yourself at ncpa] The essay that follows does not contain the backup statistics and footnotes which will appear in the formal, published version.

Inflation and Capital Gains
by Bruce Bartlett

For economists, the concept of income has always meant real income; that is, nominal or money income adjusted for changes in the general price level, by means of some appropriate index such as the Consumer Price Index. However, despite this universally held view among economists, the tax law has traditionally taxed nominal income as if it were real income. It was not until 1981 that the first provisions were added to the Tax Code partially adjusting automatically for inflation. However, much of the Code remains unindexed, resulting in economic distortion and unfairness. In particular, capital gains are not adjusted for inflation.

The standard economic definition of income used by tax theorists for more than half a century was developed by Robert M. Haig and Henry Simons, both of whom strongly advocated inflation indexing of income for tax purposes. As Haig wrote in 1921:

If income is defined as the total accretion in one's economic strength between two points of time, as valued in terms of money, it is clear that his income will reflect every change in the value of money between those two points of time in so far as the items entered on the balance sheets at those times affect the computation. If the level of prices goes up ten per cent the money value of my assets will ordinarily follow at a like rate. That particular increase in value does not really indicate an increase in my economic strength. My power to command economic goods and services has not increased, for the money-value of these goods and services has likewise increased....If it were possible to modify the concept of taxable income so as to eliminate this variation it would certainly be desirable to do so.

Later, Simons conceded that most capital gains are "largely fictitious" once inflation is taken into account. In principle, he said, tax law should adjust gains and losses for changes in the price level. "Considerations of justice demand that changes in monetary conditions be taken into account in the measurement of gain and loss," Simons wrote in 1938.

A long line of major tax theorists have consistently held to the Haig-Simons view regarding the impact of inflation on capital gains down to the present day. For example:

Jacob Viner: "No acceptable concept of income will include as income the rise in monetary value of a capital asset which represents merely the fall in the value of the monetary unit and is not indicative of increased purchasing power in general."
Richard A. Musgrave: "It is clear enough as a matter of principle that all assets and liabilities should be adjusted for changes in price level and that accretion should be measured in real terms."

Richard Goode: "Appreciation in the price of an asset that reflects only a general rise in prices is a fictitious gain because it gives the investor no increased command over goods and services."

Joseph A. Pechman: "To measure the income from appreciated assets, the portion of the capital gain that results from inflation should be deducted from the nominal capital gain."

Thus it is well established that as a fundamental matter of principle, capital gains ought to be adjusted or indexed to inflation. And a considerable amount of empirical analysis has shown that the failure to do so has caused considerable harm to millions of taxpayers.

The first important empirical analysis of the impact of inflation on capital gains was done by Martin Feldstein and Joel Slemrod in 1978. They found that the $4.5 billion in nominal capital gains reported by taxpayers in 1973 would actually have been a $1 billion loss had capital gains been indexed to inflation. But because inflationary gains were taxed as though they were real, taxpayers paid almost $500 million more in taxes that year than they should have. Interestingly, the impact of not indexing capital gains for inflation has its greatest impact on those in the middle income brackets. The greatest real losses are sustained not by the rich, but by those with incomes below $100,000. As one would expect, the inflationary component of realized capital gains tends to rise the longer an asset is held.

Perhaps the most remarkable study of the impact of inflation on capital gains, however, was done by Robert Eisner in 1980. He looked at aggregate capital gains from 1946 through 1977 and found that over this entire period there were no real capital gains whatsoever. On balance, Eisner found, households suffered a real loss of $231 billion on nominal gains of almost $3 trillion. Commenting on the Eisner study, Alan Blinder conceded that "most capital gains are not gains of real purchasing power, but simply represent maintenance (or rather partial maintenance) of principle in an inflationary world."

Congress has not been oblivious to this problem. Indeed, a primary justification for having a lower tax rate on capital gains —as has been the case throughout most of our history — is precisely in order to compensate for the effect of inflation. For example, when the capital gains tax was cut in 1978, the impact of inflation was a primary motivation for the change. As the Joint Committee on Taxation's official explanation of the Revenue Act of 1978 put it:

In addition, the Congress believed that an increased capital gains deduction would tend to offset the effect of inflation by reducing the amount of gain which is subject to tax. However, since the deduction is constant, unlike the adjustments generally provided for in various indexation proposals, it is much simpler and should not tend to exacerbate inflation. However, since 1986 capital gains have not received special treatment, except insofar as those taxpayers in marginal tax brackets above 28 percent  pay a maximum tax rate of 28 percent on capital gains. Therefore, the argument against indexing on the grounds that capital gains are already favorably treated by the Tax Code is no longer valid.

Vito Tanzi, director of fiscal policy for the International Monetary Fund, lists five reasons why indexing of capital gains has been opposed by tax experts:

1. Preferential tax treatment for capital gains has largely been justified by the existence of inflation. Therefore, in the absence of inflation capital gains would not have been taxed at a lower rate.

2. Since most capital gains are realized by the wealthy, taxation of inflationary gains makes the tax system more progressive. (Conversely, indexing would mainly benefit the rich.)

3. Many capital assets are bought with borrowed funds. Because inflation erodes the real value of borrowed funds and because taxpayers can deduct nominal interest, which may contain an inflationary component, borrowing must also be indexed for inflation or else capital gains indexing will simply become a tax dodge.

4. Indexing capital gains will lower government revenue, which, in the Keynesian model, will increase the budget deficit and exacerbate inflation.

5. Adjusting capital gains for inflation without indexing everything else for inflation as well, such as depreciation, will create unfairness and misallocate investment.

Tanzi responded to each of these arguments, finding none of them to be particularly strong. As he wrote:

The first of these arguments is not very convincing. It is true that prices have been going up in most countries since World War It, but capital gains taxation precedes that period. For example, in the United States, it was enacted in 1913 together with the individual income tax.

Up to that time, the United States had experienced more years when prices declined than when they rose. The second argument seems to be based on the assumption that inflation-induced distortions are welcome as long as they make the tax system more progressive. However, if one accepts the view that the progressivity of the system should not be the result of accidental changes but should reflect the intention of the legislators, distortions cannot be welcome regardless of whether they increase or decrease that progressivity. The third and fifth arguments are not against the adjustment of capital gains for inflation per se but mainly against improper or incomplete adjustments in the tax system.

Proper adjustments should take into account liabilities and should be extended to financial assets. Finally, the fourth argument is based on a view of the interrelation-ship between economic activity and inflation that may no longer reflect current reality.

In recent years, the strongest arguments against capital gains indexing have been administrative complexity and potential tax arbitrage resulting from incomplete indexing. For example, the New York State Bar Association issued a strongly-worded report in 1990 opposing capital gains indexing for these reasons.

In response to the first point, there is no reason why the Tax Code cannot be completely indexed to inflation, thereby eliminating arbitrage opportunities as well as other areas of inequity, such as the failure to adjust depreciation for inflation. In 1984, the U.S. Treasury Department put forward a comprehensive proposal to do just that. It is a proposal that could easily be revived.

Secondly, there are many countries that have indexed capital gains for inflation, to greater and lesser degrees, without suffering any particular problems. Among these countries are Colombia, Finland, Mexico, Spain, Sweden, Belgium, Denmark, France, Norway, Argentina, Israel, Chile and the United Kingdom. A thorough review of the Chilean case found that while complexity did increase with indexing, it was certainly not unmanageable. As the study concluded:

The complexity inherent in a program to index capital gains, with or without indexation of interest, could be managed by the [Internal Revenue] Service. If Chile, which has much more limited administrative resources than the United States, can successfully administer a comprehensive indexing program, the [Internal Revenue] Service can clearly administer a mere capital gains indexing system. Similarly, since indexation is not regarded as an unbearable compliance burden by Chilean taxpayers, U.S. taxpayers should be capable of compliance. While it may not be valid to say that capital gains indexing is impossibly complex, nevertheless it is certainly more complex than just excluding some portion of capital gains from tax. Historically, the United States has always excluded 40 percent to 50 percent of capital gains from taxation. The period since 1986, when there generally has been no exclusion, is an anomaly.

In conclusion, there is simply no justification for fiill taxation of inflationary gains. Economic theory is very clear on this point. The only question is whether to fully index capital gains for inflation, as other countries have done, or to restore a 40 percent to 50 percent exclusion, as the United States has done historically in part to compensate for inflation's eflfect on capital gains. The option of doing nothing should not be an option.

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