Indexing Capital Gains — Fool’s Gold | Wall Street Journal | 06.27.90

As the current inning in the long-running game called the budget process reaches its climax, many in Washington are betting that the congressional Democrats are about to make a double play. Getting George Bush to move his lips on taxes was their first out. Stopping him from moving them on capital gains tax reduction could be the second.

Senate majority leader George Mitchell had insisted that any change in the capital gains tax rate must be paired with a new top rate of 33% for higher income taxpayers, bursting the so-called bubble. House Republicans have said that they would wash their hands of such a deal. A number, led by Rep. Vin Weber (R., Minn.), are ready to walk out on any budget deal that fails to include action on capital gains.

But without fanfare in the press, Sen. Mitchell has begun to retreat from his demand. At the same time, some summiteers have begun informally exploring alternatives to the president’s tax cut proposal — alternatives that they hope might be acceptable to the White House and perhaps even win over the House Republicans, despite Mr. Weber’s tough line.

The president’s plan would effectively cut the capital gains rate to 19.6% after three years, by excluding 10% of gains in the first year, 20% in the second and 30% in the third. Mr. Bush argues that this cut would, among other desirable things, compensate investors for the inflation built into the appreciation of asset prices.

Opponents of the cut and now some summiteers have asked, why not take the president’s reasoning to its logical conclusion? Why not simply index capital gains to the rate of inflation instead? If inflation has totaled 15% over the time someone held a $100 asset, tax the gain on the asset as if the purchase price had been $115.

On its face, indexation appears to be a fine idea. Indexing business-related taxes was the one element of the 1986 tax reform proposal that Congress didn’t pass. Indexing capital gains would put an end to one of the principal risks of investing the danger of paying hefty taxes on non-existent real gains or even losses, without reopening such settled issues of tax reform as rates on personal income. It would remedy something that liberals as well as conservatives regard as a serious flaw in our current tax system.

Because of its obvious fairness, indexing doesn’t call forth the class warfare style of opposition that a straight capital gains cut does. Some prominent conservatives support it over the Bush proposal for just that reason. They see indexing as an achievable way to reduce taxes on capital gains, one that even dedicated adversaries of the Bush plan will favor. That means, they believe, giving up less and perhaps nothing at all to get it. As one advocate says, if Mr. Bush had endorsed indexing last year, it would be enacted by now.

The problem is that — as happens so often when taxes are the issue — different people mean different things by indexing. Full indexing would permit losses on one asset to offset gains on another and for a portfolio with nominal gains to show real losses. But full indexing, which many conservatives appear to assume the Democrats are talking about, does not command active liberal support and has no prospect of getting a serious hearing in Congress. No one in Washington has suggested that indexed valuations be allowed to drop below zero. Under proposals being discussed, if that asset with the indexed purchase price of $115 were sold for $110, the investor couldn’t show a $5 loss, just a wash.

Investors with real losses for their portfolios would thus still pay taxes on phantom gains. Among other things, “quarter indexing,” as some call this treatment, is far less expensive to the government than full indexing, which all agree would produce a big drop in federal revenue, even accounting for its stimulative effect on the economy.

Opponents of the Bush proposal refer to calculations of what a dollar would be worth after a number of years if: a) it is invested this year, b) produces a steady annual return, c) all returns on that investment are reinvested without paying the 28% personal income tax until d) the asset with its compound returns is finally sold. Looked at this way, the Bush proposal can be made to seem a minor boost to the economy compared to indexing.

But this analysis describes a limited group of companies. Only mature or stagnating companies produce smooth, predictable earnings that compound at roughly the same rate, year in, year out. New and growing businesses have different profiles. Early investors pay prices that reflect not only the returns that they hope the business will produce but their doubts that it will produce any at all. Within a few years, a company may still have little or no profits even though it has taken a large share of a growing market. It looks like a surer deal, however, and so the stock price climbs rapidly, not because of rising earnings but declining risk.

For this kind of company — the kind that in large measure has driven the current expansion and is driving virtually all expanding economies around the world — the Bush proposal will have a markedly greater impact than quarter-indexing. Simply put: the greater the capital appreciation of an investment in its first six years — the normal horizon for seed capital investments — the more powerful the incentives in the Bush proposal.

Two issues have underpinned the now decade-long tax contest in Washington: first, will there be a cap on the proportion of the economy that the government takes; and second, should policy be designed to free the economy’s dynamic and creative elements or to protect the threatened and declining ones, even at the expense of growth?

If the budget summit does indeed produce higher taxes, particularly without real reforms in the budget process and concessions on entitlements, congressional Democrats will have tagged out the administration on limiting the government’s take. If the summit also blocks the cutting of the capital gains tax rate, they will have stopped the most powerful recent initiative for advancement of the growth agenda. While indexing — even quarter indexing — might be better than nothing, it would still represent a setback on this agenda.

President Bush has now stepped up to bat. The old Yale first base man may yet hit a home run — and even a single that advances all runners will do. But right now the betting is heavy on the Democrats’ team from the Hill.