As someone who has openly supported Capital Gains Indexing for decades, I am very happy to have read recent stories about this proposal arising again in Congress. Many prior attempts to pass indexing over three decades have failed, but this time just might be different. Indexing is a common term, but may need some explanation as it pertains to capital gains. Indexing is merely an alternative method of taxing monetary gains on sales of assets.
It is important to know the difference between “real” and “nominal” profits. Nominal refers to an actual number of dollars; i.e. if you buy something for $100 and later sell it for $200, your nominal profit is $100. “Real” profit, however, reduces that profit on the same sale by the change in value of the dollar since your purchase. During your holding period, if accumulated inflation were 20%, your “real” profit would be $80.00 (nominal profit minus inflation). Indexed Capital Gains Tax would be due only on the inflation-adjusted profit of $80.
Paying tax on inflationary gains (100% of the nominal profit) has never made sense to me. Taxing only the non-inflationary gain is, on its face, a very logical proposal. However, there are several complexities, rendering passage and implementation of Indexing an intricate endeavor. In no particular order, they include:
- Our biased media complex complains that 86% of the benefit would accrue to the top 1% of income earners.
- The government reports the “cost” of indexing would be a large loss of revenue. They do not consider changes in human behavior resulting from lower taxes.
- Record-keeping requirements would be more burdensome, and the government’s inflation measure (Consumer Price Index, or CPI) would have to be applied to all purchase and sale records.
- It has occasionally happened in the past that inflation went negative for a period of time, which would result in owing extra tax if the holding period happened to correspond to a deflationary period.
Indexing is a method of reducing taxes on Capital Gains from asset sales. We have experience with Capital Gains Tax Cuts, dating back to the Clinton Administration. In the 1990s, Capital Gains Tax Rates were cut, and the resultant increase in tax revenues was astounding. Indexing is also a form of Capital Gains Tax Cut, and as such is most likely to result in increases in both economic activity and tax revenue. After all, tax cuts have worked every time they were tried. This is the crux of human behavioral changes in response to reductions in taxation.
Cutting taxes for Americans is always met with resistance from those who prefer larger and more invasive government. Still, this time I believe that the current push to Index Capital Gains may become successful. If so, income planning, tax planning, and estate planning will all be enhanced for the average citizen. One does not have to be wealthy to benefit from user-friendly tax laws. My fingers are crossed.
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