Index the Gains Tax; Don’t Cut It
After focusing for months on extraneous arguments about revenue effects (probably zero) and fairness (a red herring), the capital gains debate has taken a politically bizarre twist. The Democratic-controlled House is about to vote on a very Republican capital gains measure that would cut the capital gains tax rate to 19.6% for two years, then index capital gains to inflation.
By insisting on two years of a “differential” lower capital gains tax rate, the bill, authored by Rep. Ed Jenkins (D-Ga.), risks seeing the two years stretch on indefinitely through the actions of rate-cut supporters. And by rejecting a superior alternative plan to index capital gains for inflation right away, the Ways and Means Committee has jeopardized passage of any capital gains measure.
Indexing, which would exempt from taxes any profits up to the level of inflation, is best on economic grounds. It looks as if it would be better politics as well, in view of opposition to the Jenkins bill by powerful Democrats like House Speaker Thomas S. Foley and Senate Finance Committee Chairman Lloyd Bentsen.
Indexing capital gains on new investment, as Ways and Means Committee Chairman Dan Rostenkowski (D-Ill.) originally proposed, avoids the harmful effects of taxing illusory inflation gains and eliminates the fairness issue, since it means that taxpayers, whatever their bracket, will see their capital gains taxed as ordinary income.
Ironically, the primary opposition to indexing capital gains comes from a small segment of the business community that claims that indexing does not provide adequate incentives for high-risk investors. Says former Rep. Edward Zchau, now a high-tech executive in California, “in order to inspire patient, long-term risk capital, you have to go further” than indexing capital gains. “Going further” means cutting the tax rate on unindexed gains to 15% or 20%.
This opposition to indexing represents part of a long tradition of business community opposition to tax measures that turn out to be highly beneficial. When President John F. Kennedy in 1961 proposed a “radical” measure to spur investment with the investment tax credit, business reaction was almost uniformly negative. One accountant termed the proposal “vague, uncertain in application . . . its effect on revenue is doubtful and unpredictable.” Of course, once it was understood, the investment tax credit became one of the most popular tax measures ever enjoyed by business.
The argument for a differential capital gains rate of 15% or 20% instead of indexing capital gains comes down to a claim that the differential rate is necessary to provide adequate rewards for risky ventures.
Most economists, not to mention many venture capitalists, agree that the market already provides adequate compensation for additional risks. For example, during the 1951-88 period, for five-year holding periods, investors in the stock market who switched from less-risky S&P; 500 companies to riskier smaller companies increased their average return by 373% (from 3.05% to 11.37%) while the most common measure of risk rose by only 50% (from 7.31% to 10.93%.)
By far the oddest thing about venture capitalists and other commentators on capital gains is their failure to examine carefully the question of whether they would be better off with differential capital gains rates or indexing. Indexing wins hands down. When it comes to reducing uncertainty about the after-tax real return on an investment, indexing means that an investor is relieved of having to forecast the inflation rate to calculate the return. This is not true with a differential capital gains rate, which, once fixed, can leave the investor with inadequate or excessive protection against inflation.
Most important, indexing actually results in a lower tax rate on capital gains than the proposed 19.6% rate. For five-year investments, given a typical 4% inflation rate, indexing beats a 20% capital gains tax rate for projects with assumed annual real returns of up to nearly 20%. In short, indexing is the best way to reward the longer-term investments favored by Treasury Secretary Nicholas F. Brady. The longer an investment is held, the more gains accrue from deferral of tax, while indexing protects against erosion of real returns by inflation.
The Rostenkowski proposal even included an option whereby after five years, investors could choose between inflation indexing and being taxed on only 75% of the selling price of the asset. This option means that if, after five years, you have a project that earns more than a 32% annual real return, you would be better off under his alternative. The cost is minimal because only a tiny fraction of investment projects would consistently yield real returns over five years of more then 30%. But if the alternative made some venture capitalists feel better, more power to them.
Indexing capital gains was part of the Treasury’s original landmark tax reform proposal that ultimately led to the Tax Reform Act of 1986. Let’s hope that Congress can regroup on a sound policy to index capital gains and that the President will recognize indexing as a valuable modification to the tax code that will do more to encourage investment than any other measure.
