Is It Time for Donald Trump to Index Capital Gains to Inflation?

Last week, the Bureau of Economic Analysis (BEA) reported the U.S. economy is on track to grow at an annual rate of 3% or greater for the first time since 2005. The advance estimate for third-quarter (Q3) gross domestic product (GDP) came in at 3.5%, beating the consensus forecast.

But some argue measures being weighed by the Trump Administration and Republican-controlled House of Representatives could boost sustained annual growth to 4% or higher.

The House Ways and Means Committee and Chairman Kevin Brady, R-Texas, have worked with leadership and the White House to roll out Tax Reform 2.0. The combination of bills would most notably make the individual tax cuts from the Tax Cuts and Jobs Act (TCJA) permanent.

As a result of the TCJA, U.S. companies are repatriating billions of dollars that were parked overseas, wages and salaries are rising, business optimism has hit record highs and capital investments have soared.

A study by the Tax Foundation estimates making the individual tax rates permanent would “increase long-run GDP by 2.2%, long-run wages by 0.9 percent, and add 1.5 million full-time equivalent jobs.”

The White House is also weighing a unilateral measure via executive action to index capital gains to inflation, People’s Pundit Daily (PPD) confirmed. In light of Q3 2018 GDP coming in below 4%, the measure is gaining steam among pro-economic growth and liberty advocates.

“The economy is strong, but it has recently encountered some formidable headwinds,” Club for Growth President David McIntosh argued in a statement emailed to PPD. “In order to reinvigorate the economy and make it even stronger, we recommend that President Trump immediately sign an executive order to index capital gains to inflation.”

Investment and spending drive the U.S. economy and without the former there can be no latter. Currently, the capital gains tax rate for married couples filing jointly with an annual income between $77,201 and $479,000 is 15%.

Married couples filing jointly earning more than $479,000 are taxed at a 20% rate. As a result of ObamaCare, married couples filing jointly who earn more than $250,000 are also subject to an additional 3.8% net investment income tax.

Investments made several years prior are taxed on return, when the dollar is no longer worth the same as it was when the individual investment was initially made.

“For example, say an investor put $5,000 in the stock market in the year 2000,” Alec Fornwalt of the Tax Foundation explained. “Under the current law, if that $5,000 generously turned into $8,000 over those 18 years, they would be taxed on the $3,000 gain, resulting in a tax liability of $450.”

If current law indexed capital gains to inflation, the return wouldn’t have been as much and, as a result, neither would the individual’s tax liability.

“The problem is, in 2018, that $5,000 from 2000 is equivalent to roughly $7,100 today. Inflation accounted for $2,100 of that gain. This means the investor only really made $900, not $3,000,” Mr. Fornwalt added. “Even worse, if an investment doesn’t make more than the rate of inflation, the investor is taxed on gains that are not even gains at all. If that investor who invested $5,000 in 2000 sold the investment for $7,000 in 2018, the asset was actually sold at a real loss.”

“However, under current tax treatment, the investor would still have a positive tax liability.”

It’s unclear if action from the White House was imminent, but with the 2018 midterm elections looming, it complicates the issue. Democrats had a long history of supporting cuts to the capital gains tax until the era of Barack Obama. It was once a bipartisan issue.

“Inflation indexing is not a novel or radical idea. It has been an integral part of labor contract negotiations for decades,” said Tim Anderson, analyst at TJM Investments. “Cost of Living Increases, or COLA, have been used to peg increases in Social Security payments to inflation for at least a generation.”

But the modern Democratic Party now argues any lowering of the rate is a “tax cut for the rich.” Senate Minority Leader Chuck Schumer, D-N.Y., said the motive of indexing capital gains to inflation isn’t economic growth, but rather to “give the top 1% another advantage.”

In what was supposed to be a news story, The New York Times headline called it “a unilateral tax cut for the rich.” But for economic analysts, it’s rudimentary and elementary economics.

“Indexing capital gains to inflation will ‘smooth out’ the imbedded tax of inflation on hundreds of billions of unrealized capital gains that have been locked up in retirement and mutual fund accounts,” Mr. Anderson added. “The same is true of private equity and venture capital funds, to a much larger degree.”

While Mr. Anderson stressed the economic impact, some also see the issue as one of fairness.

“As it stands now, this is a grave injustice in the tax code, forcing people to pay taxes on phantom gains,” Mr. McIntosh added. “Just as important, an executive order would unlock hundreds of billions of dollars in capital that would spur new investment and jobs.”

The Tax Foundation General Equilibrium Model finds indexing capital gains to inflation would increase the long-run size of the economy by 0.11%. Wages would be 0.08% higher, the capital stock would be 0.26% larger, and there would be an additional 21,800 full-time equivalent jobs.

The Tax Foundation also projected the measure would reduce federal revenue by $178 billion over the next decade on a conventional basis. However, they stressed that the added economic benefit will offset some of that cost, resulting in a net dynamic revenue loss of $148 billion over the next decade.

“It would also immediately grow the savings of everyday working Americans,” McIntosh concluded. “With just his signature, President Trump can give all Americans something extra to be thankful for this Thanksgiving.”