Senate Tax Bill Faces a Fight on Capital Gains

The Senate Finance Committee has created plenty of excitement with its version of tax reform. Instead of the mishmash of tax revisions which the House chooses to call reform, the Senate committee has surprised nearly everybody by proposing real simplification. It is an appealing plan because it puts back into the income tax system some semblance of fairness.

Now the question is whether the purity of the plan can stand up to all the pressures to “fix” it. If it can’t, the Senate bill and the House measure with it should be discarded promptly. A compromise between the two, with some of the special tax preferences retained by the House and a top tax bracket closer to the House plan’s 38%, could be worse than the system we struggle to live with now.

One of those proposed fixes has to do with capital gains. Many tax experts are unwilling to see the special treatment of these gains lost, even in the name of true reform. Former presidential economic adviser Martin Feldstein is among those arguing that eliminating the special treatment would cost the government revenue rather than increase it. This is because investors would be less likely than they are now to sell stocks, real estate or other assets and have to pay the tax on the gain.

Feldstein also argues that it’s unfair to tax capital gains without adjusting for inflation. Thus, if a stock rises 5% in value in a year but inflation is also 5%, the investor has made no real money at all.

Those are strong arguments, except for two factors. One is that with the top tax bracket dropped to 27% (or 32% at some income levels) from the current 50%, there’s plenty of incentive for investment and far less reason to avoid cashing in. At present, the investor is looking at the dramatic difference between 20% on capital gains and 50% on ordinary income.

More important, restoring the special capital gains benefit is to take a big chunk of simplification out of the reform plan. The mischief the provision creates now is considerably more than meets the eye. One former tax court judge contends that it does more to fill up the court’s docket than any other part of the tax code. This is because the heart of many hot-shot tax avoidance schemes is to convert, by one means or another, ordinary income into capital gain. Some of these schemes are barely legal. Others are abuses that get wiped out the first time the court gets a crack at them.

Feldstein’s plan to provide an inflation adjustment in lieu of a lower tax rate on the gains simply substitutes one incentive for another. It must be remembered that the gains would continue to enjoy one advantage no matter what--they aren’t taxed until the asset is sold. Moreover, if capital gains are to be indexed for inflation, why shouldn’t investors in fixed-income securities--bonds and savings certificates--be given a tax offset as inflation eats into their return?

Which brings up another point: One goal of tax simplification is to get tax considerations out of the economic decision-making process. At present, the tax laws clearly distort this activity, skewing investors’ attention toward stocks that will grow rapidly from those that produce a steady stream of dividends. It skews corporate decisions toward retaining cash for further investment and a hope for appreciation in the stock and away from paying out larger sums to shareholders. In many cases, the economy would be better off if investors had that cash to reinvest rather than management.

In terms of the stock market, the current practice of charging full tax rates on short-term gains and far less on long-term gains encourages some stability in stock ownership. But the incentive to hold stock probably causes more damage in lost liquidity in the market than benefit for the economy.

The capital gains question is only one of many facing the Senate and any later Senate-House conference to resolve differences in the bills. The big gamble is with the frailty of the Senate plan. As long as it retains its character and keeps the tax rates low, it has real value. But let those rates be forced up through compromise and that in itself will foster even more massive efforts to put special considerations back into the system. Those special deals don’t matter much at 27%. They matter a lot more at 38% or higher.