November 22, 2006

Issues in the Indexation of Capital Gains

Download Special Report No. 148

Special Report No. 148

Executive Summary The nation may revisit the issue of capital gains taxation now that the Democratic Party controls the Congress. Republicans have been almost unanimous in their view that the rate cuts on capital gains and dividends in May 2003 were, among all the Bush tax cuts, two of the most successful at boosting the economy. Democrats have mostly held the opposite view, asserting that compared to the rates on wages, capital income has long been under-taxed. In one respect, though, the parties may be able to agree on a reform to capital gains taxation: indexation of capital gains for inflation.

When Congress indexed income tax brackets for inflation in 1981, it was considered such a daring reform that a four-year delay was built in. But in retrospect, like air conditioning, indexation seems like something we should never have had to live without. Inflation has increased the rate of capital gains taxation in wild fashion over the last 50 years. In some years the effective rate has been so much higher than the statutory rate that it mocked the idea of capital gains being taxed at a “preferential rate.” Even now, after two decades of modest inflation, indexation would be an excellent reform, improving the predictability of tax burdens on capital investment.

The occasional bill has been introduced in Congress to index capital gains. In the current Congress, it is H.R. 6057, sponsored by Representatives Mike Pence (R-IN) and Eric Cantor (R-VA). Although an unlikely prospect for enactment on its own, such a bill could become part of a fundamental tax reform plan.