P roposals to index capital gains for inflation have recently reentered the public debate. The proposed change would eliminate taxes on the part of capital gains that reflects inflation. It would increase the basis (the amount subtracted from sales price to determine capital gains) by inflation occurring since acquisition of the asset. President Trump's head of the White House National Economic Council, Larry Kudlow, has long proposed the indexation of capital gains for inflation through regulation, and Americans for Tax Reform has written a letter urging Treasury Secretary Steven Mnuchin to index capital gains. Past analyses (as discussed in " History of Proposals to Index Capital Gains " section below) indicate that the change would require legislation. Senators Ted Cruz and James Inhofe have introduced S. 2688 , the Capital Gains Inflation Relief Act of 2018, which would index the basis of assets for purposes of the capital gains tax. Similar bills, H.R. 2017 and H.R. 6444 , have been introduced in the House by Representative Jack Emmer and Representative Devin Nunes. Chairman of the House Ways and Means Committee Kevin Brady has indicated that some discussion of this issue is ongoing. Capital gains on corporate stock are also largely effectively exempt from income tax when they are held in a pension or individual retirement plan. Explanation of Indexing for Capital Gains

Indexing would increase the basis of the asset (i.e., the amount deducted from the sales price to determine gain or loss) by the change in the price level between the date of acquisition and the date of sale. Asset Coverage

The effect of the indexing also depends on what assets are included and whether the provision applies to both short-term and long-term gains, or some other category based on holding period. These legal issues were also discussed in a recent article by Lee Sheppard, who concluded that Treasury does not have the authority to index capital gains for inflation. How Indexing Capital Gains Compares with Fixed Exclusions or Rates

This section compares, using effective tax rates, indexing capital gains to alternative tax benefits (exclusions or lower rates) by holding period, using examples of an appreciating asset with deferral such as corporate stock, and a depreciating asset such as real estate, and a fixed asset such as land (which yields current income). Effective Tax Rates by Asset and Holding Period

 Table 1 shows the effective tax rates for investors subject to the maximum capital gains tax under present law with and without indexing for five types of assets: 
1. a no-dividend stock (a purely appreciating asset that pays no current return), 2. a stock that pays a dividend and appreciates more slowly, 3. a commercial building that earns rent and depreciates, 4. a residential building that earns rent and depreciates, and 5. an asset that earns a rent and neither appreciates nor depreciates in real value (illustrated by land). It would favor stocks that pay dividends over growth stocks. Residential buildings would receive less benefit than other real estate, and their benefit relative to stocks depends on whether they are held long enough to have little or no basis to index. Some of these patterns may not be consistent with the objectives of capital gains relief, as discussed in more detail in the following sections. Should Indexing Capital Gains be Added to or Substitute for Existing Benefits? The analysis of a variety of issues depends on whether indexing is an addition or a substitute, not only in the types of assets affected, but in concerns such as revenue cost, distribution, and lock-in effects. Economic Growth

An argument has been made that lowering the taxes on capital gains via inflation indexing would boost economic growth. The second approach divides the revenue estimate by the estimated capital stock to provide a direct estimate of the change in the cost of capital, which is 0.07%, or 7 basis points. Administrative and Compliance Issues

Indexing capital gains for inflation would be more complicated than an exclusion or lower rate, because a different inflation adjustment would have to be applied to each vintage of investments.
Recently, proposals to index capital gains for inflation have reentered the public debate. The proposed change would eliminate the part of capital gains that reflects inflation by increasing the basis (i.e., the amount subtracted from sales price to determine capital gains) by inflation occurring since acquisition of the asset. President Trump's head of the White House National Economic Council, Larry Kudlow, has long proposed the indexation of capital gains for inflation through regulation, and Americans for Tax Reform has urged Treasury Secretary Steven Mnuchin to index capital gains. Senators Ted Cruz and James Inhofe have introduced S. 2688, the Capital Gains Inflation Relief Act of 2018, which would index the basis of assets for purposes of the capital gains tax. Similar bills, H.R. 2017 and H.R. 6444, have been introduced in the House by Representative Jack Emmer and Representative Devin Nunes. Chairman of the House Ways and Means Committee Kevin Brady has indicated that some discussion of this issue is ongoing.
Capital gains already receive benefits including (along with dividends) lower tax rates, tax deferral until assets are sold, and gains exclusion on assets passed on at death. Capital gains earned in retirement and pension plans are also effectively exempt from income tax. Other types of earnings from capital (such as interest and business investments) are also taxed on nominal income, but those effects are also offset by other tax benefits.
The effects of capital gains indexing depend on a variety of features: the choice of the price index, assets covered (by type and holding period), whether indexing generates or increases losses, whether indexing applies to past as well as future inflation, and whether indexing is in addition to or a substitute for current tax benefits.
Past legislative proposals to index capital gains for inflation have never been enacted, although in some cases proposals led to alternatives such as exclusions or lower rates. In 1992, a proposal advanced to index capital gains for inflation by regulation was eventually rejected based on findings that the Department of the Treasury does not have the authority to index capital gains.
Compared with an exclusion or lower rate, indexing favors short-term assets relative to long-term ones. Indexing provides the smallest exclusion equivalents to growth stocks that pay little or no dividends and the largest equivalents to gains from land, commercial buildings, and to a lesser extent residential buildings and stocks that pay substantial dividends. Some of these patterns may not be consistent with policy objectives that may favor lower rates on stocks and assets held for a long period. Compared to an exclusion, inflation indexing would favor risky assets.
The analysis of various economic issues depends on whether indexing is in addition to or a substitute for current benefits. Questions arise as to whether interest, depreciation, and inventories should also be indexed.
As an additional provision, depending on the design, estimates suggest a range of $10 billion to $30 billion per year in revenue costs. Economic growth effects would be relatively small, with even the largest revenue estimate pointing to a decrease in the cost of capital of 6 to 7 basis points (lower required returns of 0.06% to 0.07%). Evidence also suggests that the savings effect would be small and likely to be offset by crowding out of private investment by government borrowing if debt-financed. The change would favor high-income individuals, with about 60% benefiting the top 0.1% and around 90% benefiting the top 1% in the income distribution.
Favorable treatment for capital gains on stocks has been advanced due to the double taxation of dividends, but the 2017 tax changes have made that justification less persuasive. Capital gains indexing would reduce the distortion between debt and equity but increase the favoritism of retaining earnings over paying dividends. It would reduce the lock-in effect that causes individuals to retain current assets because of the tax, although not as much as an exclusion equivalent. Administrative and compliance costs would increase because each vintage of assets would require a different exclusion, but improved computing facilities make that issue less burdensome.