Capital Gains Tax: Are We Doing It Wrong?

SMITH BRAIN TRUST – A dollar doesn’t go quite as far as it used to, right? So shouldn’t that fundamentally alter the way the IRS calculates capital gains? That’s a question being bandied about lately.

Critics of the tax have suggested that the calculation factor in inflation, adjusting the gain by indexing the original cost basis. The Smith School’s Samuel Handwerger has been watching the debate closely.

“What makes the current discussion interesting is that the change might not be made by an act of Congress,” says Handwerger, a lecturer in the accounting and information assurance department at the University of Maryland’s Robert H. Smith School of Business.

Kevin Brady, the chairman of the House Ways and Means Committee, is weighing capital gains indexing while the committee mulls yet another tax cut.

The Trump administration, meanwhile, is also said to be thinking about capital gains calculations, under the guidance of professed indexing fan, Larry Kudlow, the director of the White House’s National Economic Council. 

What makes the current discussion interesting is that a change, if adopted, might not require an act of Congress. “It might be born out of regulation from the Treasury Department goes the theory,” says Handwerger.

The Internal Revenue Code states that the basis of property for purposes of determining gain shall be its “cost,” a term that the Supreme Court in 2002 deemed ambiguous, Handwerger explains.

The argument has been proffered that ”cost” for purposes of capital gain can be regulated by the Treasury to mean “as adjusted for inflation,” making the indexing an interpretive part of the law rather than specifically statutory. “This would certainly spark some interesting controversy as to whether the Treasury is overstepping,” says Handwerger.

He offers an example: Say you bought a stock at the start of 2008 for $2,000. Ten years later, at the end of 2017, you sell it for $3,500, a raw dollar profit of $1,500. Under today’s tax laws your tax computation would be based on the capital gains tax rate times the gain of $1,500. 

Now re-stating the original basis of $2,000 in today’s dollars, which is effectively taking into account inflation, the basis today would be $2,323, meaning that the economic gain was really only $1,177 ($3,500 minus $2,323). Taxing the gain as $1,500 is taxing part of the inflation, not the true gain, according to the proponents of this change.

The indexing for inflation idea is not new.

In 1981, under the Reagan administration, tax rates came under indexing for inflation and since then other parts of the U.S. tax code became indexed as well. “Capital gains is one of the last battlegrounds,” Handwerger says.

However, he reminds, indexing for capital gains is not as simple as it sounds. You must first select the appropriate price index. Tax basis isn’t always as straightforward as it was in the stock-price example. For example, Handwerger says, how do you make the calculation when you have reinvested dividends?

Further, capital gains are already at tax-preferred tax rates, which range from a low of zero percent for low-income taxpayers to 20 percent for high-income taxpayers. At first glance, indexing looks like a break mainly for the wealthy and adds to the growing federal deficit to boot. 

“Sounds like a political hot potato? It is,” he says. 

And the topic calls to mind the larger issue of whether investments should be taxed at all, he says. 

“The average worker brings home income that is taxed and then that worker ‘consumes’ the net leftover and taxation stops – even if the consumed goods bring utility,” Handwerger says. “The saver, on the other hand, puts something away for the future, the fruits of which will be taxed yet again in the form of tax on interest, dividends or capital gains. In essence, the same dollars are getting taxed twice.”

But, he says, that’s a debate “for another day.”