The old fight over indexing the basis for the capital gains tax is starting up again, and this is shaping up to be the best chance ever to finally end the unfair tax on inflationary gains. Legislation sponsored by Reps. Mike Pence of Indiana and Eric Cantor of Virginia, H.R. 6057, would use the Gross Domestic Product implicit price deflator to index the capital gains tax basis for inflation, ending one of the most egregious practices of our tax system. Perhaps more encouraging, it may be possible for the president to introduce indexing administratively, without the passage of any legislation.
The capital gains tax is currently applied to the difference between the sale price of an asset and its acquisition price, adjusting for any capital improvements, but not for inflation. Because there is no inflation adjustment, for a long-held asset, the capital gains tax is largely an inflation tax. When the government levies a tax on assets that have depreciated in real terms, it is actually confiscating assets, which is a violation of basic principles of fairness.
Ten years ago, the legacy of double-digit inflation and real asset depreciation during the 1970s and early 1980s cast a big shadow on the economy, and several studies showed the enormous impact of applying the capital gains tax to inflationary gains. In a remarkable 1995 study for the Tax Foundation, Arthur P. Hall found that the effective tax rate on real capital gains was consistently far higher than the then-statutory rate of 28%, indeed consistently higher than 100%.
Ultimately, the capital gains tax relief that was included in the Tax Relief Act of 1997 took the form of a rate cut, from 28% to 20%, subsequently reduced to 15% in 2003, but the tax on inflation was left in place. Though the lower tax rate somewhat limits the bite of the tax on inflationary gains, it does not alleviate the tax's fundamental unfairness, nor provide protection against the re-emergence of more rapid inflation.
I reproduced Mr. Hall's methodology to evaluate the impact of not indexing the capital gains tax for stock investments sold now. Remarkably, even with the current statutory capital gains tax rate of 15%,an investment in an average stock, represented by the S&P 500, five years ago and sold today would face an effective real capital gains tax rate of 135%, because nearly all of the gains, 89%, over that period were inflationary.
This is a result of the stock market collapse wiping out real gains over that particular time period, an apparently one-time event, but it is worth remembering that stock markets were basically flat in real terms for about two decades before the return of monetary stability in the 1980s. With inflation now running at about 4% over the past year, and the stock market outlook uncertain, the tax on inflationary gains may re-emerge as a major deterrent to investment and growth.
The Pence-Cantor bill would be an excellent vehicle for finally ending the inflation tax, but if Congress fails to act, the president should instruct the Treasury Department to index the capital gains tax basis for inflation administratively. The Internal Revenue Code defines a capital gain as the value of an asset when it is sold less its cost, but "cost" is not defined in the code. A regulation interpreting cost in real economic terms would almost certainly pass the reasonableness standard that courts would use in reviewing Treasury Department discretion in the matter.
It has been a decade since the Contract-with-America Republicans led the last major push for this reform, and since then many of the young, enthusiastic House staffers who were in that fight have moved on to positions of influence in the Treasury Department. Thus, the stage may finally be set for ending this long-running battle with a pro-growth victory.
Mr. Kerpen is a policy analyst in Washington.