Anyone with taxable profits in real estate or stocks will love this remarkable proposal, which can cut the average capital-gains tax almost to zero (table). As a practical matter, however, the bill is a Newtron bomb. Its appalling complications would add volumes to the tax regulations and hours to your paperwork. The cuts – far too deep to pay for themselves in revenue growth – are projected to add from $54 billion to $61 billion to the federal deficit over five years. And the rules invite tax-shelter abuse. You’d have another chance to blow your life savings on Wall Street frauds, in case you missed it the last time around.
Leaving aside for a moment the merits of slashing the tax, take a look at how this sucker computes.
One part is easy. Half of all your long-term gains (on investments held for more than a year) would be sheltered entirely from tax. The mischief lies in the other part. It adjusts your investments by the quarterly inflation rate, going back to the end of 1994. For example, say that you ran a $1,000 investment up to $1,600 and during that time inflation rose by 10 percent. Today, you’d be taxed on the full $600 profit. Under the GOP proposal, your original cost would be scaled up to $1,100 (the 10 percent inflation adjustment) – leaving you a reported gain of only $500. Half of that amount, $250, would be subject to tax.
Backers of the bill say it’s fair to quit taxing “false” gains that merely offset your losses to inflation. But surely, sheltering half the profit is enough to achieve that end. Indexing isn’t nearly as simple as it sounds, says Michael Schler, tax partner at the New York law firm of Cravath, Swaine & Moore. Try these examples on for size:
If you reinvest mutual-fund dividends, every reinvestment would have to be figured at a different inflation rate. The mutual fund could use indexing, too, so detailed rules would be needed to coordinate its inflation adjustments with those of its various investors.
Bonds are not indexed. If you had a stock-and-bond fund, your inflation adjustment would be keyed to the percentage of stocks in the fund’s portfolio each month.
If you own your home, every home improvement is treated as a reinvestment. But for long building projects, time would become an issue. If you added a deck and paid for it over two calendar quarters, you’d have to allocate the cost and index it at two different rates.
For partnerships and corporations . . . never mind. It’s too disheartening to go on. Didn’t you say that you wanted the government off your back?
The tax-shelter angles will gladden any hungry heart. To take a plain example, the GOP plans to index assets but not debts. I could get a $10,000 home-equity loan at 8 percent interest and buy a shelter with an 8 percent yield. Later, I’d sell for $10,000 and repay the loan. The income from the shelter would cover my interest, so my only cost is this shell game’s expenses. But with 3 percent inflation, I’d win a $300 tax loss to play with. Under the bill, half the loss could offset ordinary income; the full loss could still offset capital gains. Enforcing compliance would be a nightmare, as shelter mavens sought to convert unindexed assets into capital gains.
The proposed tax cut raises other issues, too. For example, it’s glaringly inefficient. It favors stocks over bonds, real estate over bank accounts and certain types of business investment: a government interference in the market’s normal allocation of capital.
Backers continue to insist that lower taxes on capital gains will raise the number of transactions and produce more government revenue. That did indeed happen after the four cuts made since 1978. But in other years, transactions and revenues rose after tax rates were increased, so investors aren’t moved by rates alone. The best evidence suggests that cuts in the tax rate affect market-timing decisions (“Shall I sell this stock now or not?”) but not necessarily long-term decisions (“This is a stock I bought for keeps”). One thing’s for sure: it’s hard to raise money from tax rates that descend to zero. Studies by Jane Gravelle of the Congressional Research Service suggest that the ultimate cost of this tax cut will be much higher than what’s projected now.
Indisputably, this tax cut indulges the rich. Of all net long-term capital gains reported to the IRS, including gains on homes, 51 percent go to taxpayers with incomes topping $200,000, although this group accounts for less than 1 percent of all tax returns. Only 21 precent go to those with incomes under $50,000. Capital-gains cuts do not affect your retirement plans, withdrawals from which are taxed as ordinary income.
Anyone who mentions the tilt toward wealth gets attacked for wanting to “punish the successful” (successful being defined as rich). I’d put it another way: the rich owe more than others to the system that has freed them to earn so much. Some preference for capital gains makes sense; a low cost of capital promotes economic growth, says Arthur Hall, senior economist of the Tax Foundation. But this giant tax cut will have to be funded with bloody cuts in government spending. Better to whack at the deficit instead.
