The Next Illegal, Costly Tax Cut for the Rich: Indexing Capital Gains

Key Findings

Proposals to index taxes on capital gains for inflation would:

• Overwhelmingly benefit the richest 1 percent and increase the deficit by nearly $1 trillion over a decade¹
• Reduce taxes on a type of income that is already taxed far more generously than other types of income
• Lead to economic distortions and tax avoidance
• Violate the law if done by the executive branch alone, without Congress

While the term “indexing capital gains for inflation” means little to most people, it is a massive tax cut for the richest Americans that conservatives have proposed for more than 30 years, most recently as a bill in Congress introduced by Sen. Ted Cruz.

The proposal would cut taxes for people with significant assets by calculating capital gains (profits from selling assets) in a way that would make them smaller, resulting in less income for the wealthy to report to the IRS.

Because Sen. Cruz has been unable to get his bill enacted even when his party controls the House, Senate and White House, he has asked the Trump administration to provide this same tax cut unilaterally through regulations.

Most of the benefits would go to the richest 1 percent and nearly all would go to the richest 20 percent of taxpayers.

A capital gain is usually calculated as the price a taxpayer received for selling an asset minus their cost of acquiring it. Sen. Cruz’s proposal would increase the cost of acquiring the asset to reflect inflation, which would result in a smaller capital gain to be reported by the taxpayer to the IRS.

While this may seem technical to the casual observer, it has enormous consequences for wealthy investors, for whom capital gains are often the main source of income, and the fairness and functioning of our tax system.

Inflation-Indexing Proposal Would Favor a Type of Income Already Taxed Less Than Others

A capital gain is the profit made from selling an asset for more than it cost to acquire it. For example, if Taxpayer A (A from here on) purchases a share of stock today for $1,000 and sells it a decade later for $2,600, the $1,600 profit A makes on that stock sale is a capital gain.²

Proponents of inflation indexing for capital gains argue that if it costs $1,400 a decade from now to buy what we could purchase for $1,000 today, then $400 of the $1,600 profit on that stock sale is not really income but rather inflation and should therefore not be taxed. By reducing the amount of income reported to the IRS on the stock sale from $1,600 to $1,200, they would reduce the income tax paid by a fourth.³

One serious problem with this argument is that capital gains are already taxed dramatically less than other types of income that, by the same logic, include inflation.

For example, imagine Taxpayer B (B from here on) purchases a 10-year corporate bond for $1,000 that pays out at $2,600 a decade later. Just like A, B invests $1,000 and receives income (nominally, at least) of $1,600 a decade later, before taxes. If $400 of A’s income is inflation, the same must be true of B’s income as well.⁴

But the legislation sponsored by Sen. Cruz, and the regulatory change he is urging upon the Trump administration, would provide an inflation adjustment only for A’s capital gain income from the stock sale, not for B’s interest income from the corporate bond.

A’s capital gain is already, under current law, eligible for three tax breaks that are not available for B’s interest income.

First, A is allowed to defer paying income tax on the capital gain until selling the asset at the end of the decade.⁵ B, on the other hand, is required to pay income tax on interest annually throughout the decade.⁶ Even if the taxes paid by A and B were nominally the same, inflation would ensure that the tax paid by A at the end of the decade is less than the tax paid by B each year before the end of the decade.

Second, most capital gains, when they are finally taxed, are subject to lower rates than other types of income. The taxes paid by A are not nominally the same as those paid by B but in fact much lower. Capital gains on an asset owned for more than a year before it is sold are taxed at a top rate of 23.8 percent.⁷ Most other types of income, including B’s interest on their corporate bond, are taxed at a top rate of 40.8 percent.⁸

Third, capital gains are never taxed at all in situations where a taxpayer holds onto an asset for the rest of their life and leaves it to their heirs. If A chose to never sell their stock and it was inherited by A’s heirs, the $1,600 (and any other increase in the stock’s value before A’s death) would escape the income tax forever.⁹

Even assuming A sells their stock at the end of the decade (meaning the first and second tax break for capital gains are relevant but not the third) the tax paid on the resulting income is about 51 percent of the tax B pays on their interest income from the corporate bond.¹⁰

Proponents of Sen. Cruz’s proposal are essentially arguing for a fourth tax break for capital gains. This would allow A in this example to pay tax equal to just 39 percent of the tax B would pay on their interest income despite making an investment that is economically equivalent.¹¹

Inflation-Indexing Proposal Would Distort Investment Decisions and Encourage Tax Avoidance

In the example above, investing $1,000 in either the stock or the corporate bond seems like an identical choice, but the tax rules treat them differently and Sen. Cruz’s proposal would increase that disparity. This could encourage taxpayers to make decisions that are not efficient from the perspective of generating profit and generating value for society but only make sense as tax avoidance strategies.

For example, instead of purchasing a 10-year corporate bond for $1,000 that pays $2,600 at the end of the decade, B could lend $1,000 to A to be repaid with interest in a lump sum of around $2,600 in a decade. A could use the loan to purchase another share of the $1,000 stock and then sell it for $2,600 at the end of the decade, which they would then use to repay the loan from B.

Why would A bother to do this if proceeds from the stock sale would be entirely offset by the interest on the loan? Because the interest on the loan could be deducted from other income A has that is taxed at a top rate of 40.8 percent while the capital gain from the stock sale is taxed at a rate of only 23.8 percent.¹²

If A has other investment income that is taxed at ordinary tax rates (like interest income from bonds) then deducting $1,600 against that income will create tax savings that are larger than the tax paid on $1,600 of capital gains. In fact, A might be willing to pay a higher interest rate to B in order to achieve these savings, so that this arrangement is more attractive to B than purchasing the corporate bond which otherwise seems like a similar investment.

Illegal Under the U.S. Constitution If Done by the Executive Branch

Obviously, Congress can and often does pass legislation providing ill-conceived tax breaks for the rich that are signed into law by the president. Sen. Ted Cruz of Texas has attempted to do this during several Congresses as he has introduced and reintroduced his bill to index capital gains for inflation in the tax code.

But Sen. Cruz has not been able to get his bill through Congress even when his party controls both chambers, as they do now. So rather than enacting his legislation in Congress as clearly required under the U.S. Constitution, Sen. Cruz has asked the Trump administration to provide this same tax cut unilaterally through regulations.¹³

The section of the tax code describing how capital gains are calculated states plainly that “[t]he basis of property shall be the cost of such property.”¹⁴ In other words, Taxpayer A’s basis in the example above is the $1,000 cost to acquire the stock at the start of the decade. Sen. Cruz and other proponents of his proposal claim that the Treasury Department can interpret “cost” to mean inflation-adjusted cost, which would be $1,400 in this example.

The widespread view among tax law experts is that it would be illegal for the Treasury Department to issue regulations providing this new capital gains tax cut.¹⁵ In the 1990s the Treasury Department and the Department of Justice under President George H.W. Bush issued a memo coming to the same conclusion.¹⁶ Last year, the U.S. Supreme Court made it clear that an agency cannot extend the law beyond what Congress intended.¹⁷

The rule of law, however, has not always stopped the Trump administration from doing this sort of thing. Just one example is Treasury’s recent proposed illegal regulations allowing huge companies to avoid the corporate minimum tax that was enacted under former President Joe Biden.¹⁸

In theory, someone can sue the federal government to block tax regulations that violate the tax code. This is certainly true when the regulations raise somebody’s taxes. But it is far from certain whether federal courts will find that anyone has standing to sue over regulations that reduce taxes. They have found in some situations in the past that no one suffers specific, concrete harm from tax reductions and therefore no one has standing to sue over them. Legal scholars have debated the question of standing in the event that the executive branch attempts to provide capital gains indexing unilaterally, and the answer is still uncertain.¹⁹

In other words, it is uncertain that anything can stop the Trump administration from creating yet another tax break out of thin air – even though it is illegal. What has prevented previous Republican administrations from providing this tax break for the rich is a norm that Treasury Department officials faithfully implement laws and not attempt to create their own. We may soon find out whether this is another norm to be dismantled by Donald Trump.