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Taxing “Real Gains” – Indexing Capital Gains for Inflation


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8/5/2018
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Taxing “Real Gains” – The Treasury Proposal to Index Capital Gains for Inflation by Way of Regulation

Treasury Secretary Steven Mnuchin told the New York Times last week that the Trump Administration plans to propose a cut on capital gains (indexing gains for inflation), and is prepared to institute the measure unilaterally through the Treasury without bringing the proposal before Congress.  He said that if there wasn’t Congressional support, “we will look at what tools at Treasury we have to do it on our own and we’ll consider that.”

We tax people, whether through income taxes or capital gains, on a growth in wealth.  Because inflation-related gains do not represent an actual growth in wealth over time, there is no argument that could be made that this is a “fair” tax.  Nonetheless, because the tax disproportionately affects wealthier Americans and would theoretically reduce revenues received by the government, it has vocal detractors.  The idea that the capital gains tax cut could be implemented without a vote has been a scandal in certain circles.

"This unilateral action would almost exclusively benefit the wealthiest Americans, add $100 billion to the ballooning deficit, further complicate the tax code, and ignore the need for Congressional sanction," senators, led by Finance Committee ranking member Ron Wyden (D-Ore.), said in a letter to Mnuchin back in May.

Trump is not seeking to bypass Congress to enact a tax cut, White House deputy press secretary Hogan Gidley said on board Air Force One while traveling to Tampa, Fla., in response to criticism from detractors who are wary of changes to tax policy that are enacted without a vote.  "There's been a great deal of interest in this provision for a long time," Gidley added.

The capital gains cut would come from indexing capital gains from inflation.  In theory, if your stocks go up in value, part of that increase is attributable to the inflationary pressure on prices rather than corporate advances.  Should you be taxed on those inflationary gains?  The Trump Administration says “no.”  But, there are many critics who note that we have no chance of being able to fund social security and other entitlements as it stands, and further whittling away at the tax base would only compound the problem, rather than correcting it.

Supporters of the measure are just as ardent.  Americans for Tax Reform President Grover Norquist is strongly in favor of indexing and repeatedly urged Mnuchin to take action to enact capital gains indexing regulations. 

So, how would this work?

Example #1:

Let’s assume you bought $100 of Apple (APPL) stock in 2002.  Today, that stock would be worth $10,656.24, a whopping 100X return on investment.

You have a family and make over $500,000 a year, so you are in the 20% long-term capital gains bracket.  The capital gains tax due would be $2,111.24.

But, under Mr. Mnuchin’s proposal, you would not include the increase in stock price attributable to inflation as measured by increases in the consumer price index (“CPI”) in the taxable amount subject to capital gains tax.

Between 2002 and 2018, the Bureau of Labor Statistics has determined that the price of a basket of consumer goods and services has risen in cost by 40.07% with prices rising, on average, about 2.13% per year.  If an item cost $1 in 2002, it costs $1.40 today.

The calculation works like this.  You would index the $100 investment for inflation and count the basis in the stock at $140.  The capital gain would be calculated on $10,516.24 ($10,656.24 - $140).  The tax due on that capital gain at 20% would now be $2,103.24.  You saved $7.99!

Obviously, the effects are not too dramatic when you experience a 100X ROI, but what happens if you invest and experience a more modest gain relative to your investment?

Example #2:

Let’s say you bought $5,000 of stock in 2002 that is now worth $10,000.  You want to calculate your long-term capital gains tax if you sell today.  Today, you’d pay 20% of $5,000 in capital gains taxes, or $1,000.

What about under Mnuchin’s plan?  Indexing the $5,000 for inflation gives you a CPI-adjusted cost basis of $7,000.  The gain is $3,000.  The 20% tax on that gain is $600.

Thus, your capital gains tax would be $600 versus $1,000, a tax savings of 40%.  A tax savings exactly in line with the effect of inflation on the price of your stock.

Can the Treasury “Re-Write” the Code As to What “Basis” Means For Capital Gains Taxation Without Bringing the Measure Before Congress?

In Mayo Foundation v. United States, 562 U.S. 44 (2011), the United States Supreme Court upheld the Treasury Department’s interpretation of who constituted an tax-exempt “student” under federal FICA statutes they enforced.  The import of the case is that the Treasury Department arguably could interpret what “cost basis” in a stock means in like fashion, and have its interpretation upheld by the Supreme Court.  That is, the Treasury could by-pass Congress entirely and index inflation for Capital Gains on its own volition.

The Mayo case called on the Court to decide if Medical Residents at the Mayo Clinic were “exempt” from FICA (Social Security) taxes by virtue of the fact their employment was “incident to” their studies.  Neither the Treasury nor the Social Security Administration considered clinical residents to be “exempt students” under their regulations because these “students” were basically working full-time and remunerated accordingly, as compared with, for example, a Teaching Assistant working 10-hours a week as part of their curriculum.  The Supreme Court found that the Treasury had the power to interpret the FICA statutes they enforced through Treasury Regulation 26 U.S.C. § 3121(b)(10) and to interpret those laws as they saw fit, and upheld the denial of the “student exemption” for clinical residents at the Mayo Clinic.

Nonetheless, the same “capital gains indexing” regulation was rejected during the George H.W. Bush administration because it was seen as outside the scope of Treasury's authority and only attainable via an act of Congress.  White House lawyers at the time felt that a change of this magnitude was so significant that Congress would have spoken on the topic directly if they intended the Treasury to have this power and there was a limit to the extent of Chevron deference.  But, Congress has not spoken on the issue, and as will be explained a few sections down, Chevron leaves administrative agencies like the Treasury with the ability to “fill-the-gaps” when statutes are ambiguous as to a specific issue.

Is This a Good or Bad Policy?

Detractors of a capital gains tax cut premised on indexing for inflation point out that more than half of the benefit of such a tax cut goes to the top 1/10th of 1% of wealthy Americans.

On the other hand, paying the capital gains tax at all is “purely voluntary” in that you can just hold and wait for a brighter tax picture rather than selling when capital gains rates are high.

As a result, “real revenues” from capital gains spike and the receipts by the federal government go up whenever capital gains rates fall to more manageable levels.

Therefore, the nominal increase/decrease in revenue receipts is hypothetical at best.  Generally, all things being equal, as taxes fall the economy expands, and revenue receipts increase.  But, the problem of runaway budgets will only be solved by reducing spending and even a 100% tax on all income isn’t enough to tax our way out of the imbalanced spending to GDP ratio facing America.

What Are the Arguments For & Against “Presidential Indexing”?

The right of executive branch agencies to "fill any gap left, implicitly, or explicitly by Congress" in a statute was articulated in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).  Under Chevron, in order to reject an executive branch interpretation the courts must decide "whether Congress has directly spoken to the precise question at issue." Id. at 842-43. There is no doubt that Congress has never spoken to define the “cost” of a capital asset, even though it has considered the matter on several occasions and declined to pass legislation on the topic.

The Chevron decision permits executive branch agencies to fill-in-the gaps, stating that, "if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute." Id. at 843.  Under Rust v. Sullivan, 500 U.S. 173 (1991), a case concerning a prohibition of federal funds to organizations aiding in abortions, the Supreme Court stated that an executive agency’s interpretation must be followed on an ambiguous issue as long as "it reflects a plausible construction of the plain language of the statute and does not otherwise conflict with Congress' expressed intent." Id. at 174.

Nonetheless, the matter of capital gains indexing for inflation was considered and rejected by White House Counsel during the Bush Administration.  Similarly, in 2014, a memorandum from the Office of the Legal Counsel for the Treasury Department entitled “Legal Authority of the Department of the Treasury to Issue Regulations Indexing Capital Gains for Inflation,” by Timothy E. Flanigan concluded that Presidential Indexing was not legally authorized by way of regulation. Id. at 1992 OLC LEXIS 57 (1992).  Referencing the provisions for determining “adjusted basis” under Sec. 1012 of the Internal Revenue Code and accompanying regulations – 26 C.F.R. § 1.1012-1(a) (1992)("The cost [of property] is the amount paid for such property in cash or other property”) – Mr. Flanigan eventually reached the conclusion that the word “cost” in Section 1012 of the Internal Revenue Code is not “ambiguous” and therefore the Treasury lacks the authority to “fill the gaps” under Chevron to interpret its meaning.  Therefore, issuing regulations interpreting “cost” as “inflation-indexed cost” would not be a reasonable or plausible construction of the statute and would conflict with Congress’ expressed intent.  The Treasury could not legally pass such regulations.  Was Mr. Flanigan right?  I don’t think so.

Mr. Flanigan himself points out that the fundamental tenant of “horizontal equity” which the Internal Revenue Code embodies is offended by the taxation of inflationary gains as opposed to real gains – in other words, the current system is unfair and deeply flawed when measured against the principles of “fairness” and “parity” contained in the Code itself. 

“Horizontal equity” just means that similarly situated people should be treated the same.  If two people with equal wealth who are taxed at a 20% capital gains rate each have the value of their shares double from $100 to $200 (an equal growth in wealth), but Person #1 has this occur between 2002 and 2018, and Person #2 has this occur between 2016-2018, Person #2 experiences a 20% tax on “real gains” while Person #1 can attribute 40% of the value of his gain to inflation, not “real gains.”  Person #1 who held his stock for the long haul is treated disparately and pays 40% more taxes relative to his growth in wealth that Person #2.  This violates the fundamental tenant of the tax laws that similarly situated people be treated the same and also disincentivizes long-term investment, tying up assets, which may have unwanted collateral consequences of the same variety that the preferential capital gains rate was first instituted to avoid.

But, Mr. Flanigan concludes, with sparse authority for the idea, rather summarily, that the drafters of various versions of the Internal Revenue Code chose a lower capital gains rate (compared with the income tax rate), in part, to account for the effects of inflation.  There simply isn’t any support for that idea when one considers the actual history. 

The actual expressed intent of preferential gains has always been that it is a revenue-raising measure that is used to incentivize sales/investments (i.e., disincentivizing tying-up assets indefinitely) and which has the byproduct of simultaneously promoting the availability of capital for innovative and productive corporate ventures, since for every seller of stock who is willing to consolidate gains and pay tax on them, there is a buyer ready to deploy his capital to earn a return, making for a robust and liquid market for corporate capital.  Moreover, 9 times out of 10, that seller that starts the economic ball rolling will reinvest the principal, if not part of his gains, too, further increasing economic activity.

Consider that from 1913 to 1921 capital gains were taxed at the same rate as income taxes, which resulted in stagnant and stalled economic activity, with assets “locked-up.”  The concentration of wealth and capital assets, which were not being sold had a host of negative effects on the economy. Sidney Ratner, American Taxation (New York: W. W. Norton & Company, Inc., 1942), p. 408.  That problem called out for correction and Congress struggled to find a way to incentivize wealthy individuals and companies to sell capital assets (i.e., real estate, machinery) and stock in order to stimulate economic activity and growth.  They failed to come up with a way to do this or to make any inroads to the problem.

Shortly after the Revenue Act of 1913 (the “Tariff Act”) set these policies, the rumblings of World War I began, and in the Revenue Act of 1916, a main purpose of raising tax rates and instituting an Estate Tax was to fund the war effort.  This was followed up with the War Revenue Act of 1917, pushing rates higher as the war continued and then concluded in 1918.  1917 was the first year in which government funding passed into the billions and the Treasury saw its revenue receipts increase more than 5-fold, dramatically increasing the power and reach of the federal government.

From 1922 to 1933, long-term capital gains were taxed at the lower rate of 12.5%, which was very low as compared with the 65% rate imposed on ordinary income. Revenue Act of 1921, § 206(b), 42 Stat. 227, 233.  Legislators of the time opined that a preferential capital gains rate would unlock economic activity that might be put on hold by tax considerations – buyers would make attractive offers, sellers would sell more readily without fear of huge excises, more transactions would be taxed and this would – increase revenue.  A vocal proponent of preferential capital gains rates, Congressman Green remarked on the House floor, “[preferential capital gains rates] will reduce the rates in many instances which people will pay on sales of real estate and in some instances on sales of personal property that are capital assets, but it is quite certain that it will bring about sales which otherwise would not occur…the ultimate working out of this would bring more revenue into the Treasury.” 61 CONG. REC. 5289 (1921) (statement of Rep. Green).

So, I think the premise for Mr. Flanigan’s argument that Congress did speak on indexing for inflation and did determine conclusively what “cost” means under Sec. 1012 is flawed.  Thus, his argument falls apart.

The more compelling arguments he makes are that cost means “the price paid for a thing” under a plain reading of the statute, backed-up by dictionary definitions and expositions of the meaning of “cost” in various Treasury decisions.  These arguments, though more compelling, are equally flawed, and can be readily dispensed with.

Terms in the Internal Revenue Code often have a general meaning throughout, but a more specific meaning in the context of a particular provision and when it comes to capital gains — which measures “taxable gains”— it makes little sense to import the general “cost” concept used for depreciation calculations (§§ 167-8, 179, 197) or for trade or business expenses (§ 162) or for like-kind exchanges (§ 1031).  In each of these cases the use of the “cost” concept is static in that time or inflation does not act to distort the economic reality of the transaction.  With capital gains it does.  So, it makes no sense to conflate apples and oranges and use terms out of context.  That is not what is suggested in statutory interpretation by adopting the “plain meaning” of words.

In Verizon Communications Inc. v. Federal Communications Commission, 535 U.S. 467 (2002), the Supreme Court held that FCC regulations under the Telecommunications Act were authorized because the legislation itself didn’t speak directly to what “cost” meant “in that context” and therefore the plain language was ambiguous and subject to agency clarification.  More to the point, Justice Souter noted that the plain meaning mode of statutory construction doesn’t have the same force with respect to “technical context[s]” in which it is more reasonable to defer to the administrative prerogative than to look back to the dictionary definition of a word.

Justice Souter wrote, “This court rejects the incumbents' argument that "cost" in § 252(d)(1)'s requirement that "the ... rate ... be ... based on the cost ... of providing the ... network element" can only mean, in plain language and in this particular technical context, the past cost to an incumbent of furnishing the specific network element actually, physically, to be provided, as distinct from its value or the price that would be paid for it on the open market. At the most basic level of common usage, "cost" has no such clear implication. A merchant asked about the "cost" of his goods may reasonably quote their current wholesale market price, not the cost of the items on his shelves, which he may have bought at higher or lower prices.” Id. at 497-501. (emphasis added).

On balance, Congress has not addressed the meaning of “cost” under Sec. 1012 and the Treasury may just as easily pass regulations to interpret the statute as Congress may act to pass legislation specifically addressing the topic.

Congressional Approaches for Capital Gains Indexing

On July 19th, Representative Devin Nunes (R-CA) introduced in the House the “Capital Gains Inflation Relief Act” H.R. 6444 to accomplish through legislation what the Trump Administration is considering having the Treasury Department do unilaterally.  The measure was referred to the House Ways and Means Committee for action. 

“This bill will continue the tax-cutting trend that began with the tax relief bill last year,” Nunes said in a statement Friday. “This is a common-sense reform that will remove an unjust tax, contribute to economic growth, and help both large and small investors keep more of their own money.”

A companion bill, the “Capital Gains Inflation Relief Act of 2018” S.R. 2688 was introduced in the Senate by Senator Ted Cruz (R-TX).  That measure was introduced back on April 17th and has been pending action in the Committee on Finance.  Since a number of members of the Senate Finance Committee oppose the measure, it is unlikely to gain much traction in the Senate.  Notable committee members opposed to capital gains indexing are ranking member Ron Wyden (D-Ore.), Robert Menendez (D-NJ), Tom Carper (D-DE), Bob Casey, Jr. (D-PA), and Sherrod Brown (D-Ohio).

60 votes would be needed to pass the measure in the Senate, so it is unlikely that there is sufficient support for a legislative passage given the current Senate make-up of 51 Republicans and 49 Democrats.

****

SOURCES CITED AND ADDITIONAL READING

As a 1998 Congressional Budget Office report stated, “a preferential rate on nominal [capital] gains provides a rough adjustment for the fact that some gains reflect inflation instead of real increases in purchasing power.” “How Capital Gains Tax Rates Affect Revenues: The Historical Evidence,” March 1988, https://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/84xx/doc8449/88-cbo-007.pdf.  See also Leonard Burman, Statement before the House Committee on Ways and Means and the Senate Committee on Finance on Tax Reform and the Tax Treatment of Capital Gains, September 12, 2012, https://www.taxpolicycenter.org/sites/default/files/alfresco/publication-pdfs/904606-Tax-Reform-and-the-Tax-Treatment-of-Capital-Gains.PDF.

https://www.weeklystandard.com/the-editors/tax-cut-by-fiat

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http://www.in2013dollars.com/2002-dollars-in-2018

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Category: Tax Law


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