Four Reasons the GOP’s Latest Tax Scheme Is a Terrible Idea, According to a Conservative Tax Wonk

US President Donald Trump speaks during an event establishing the US Space Command in the Rose Garden of the White House in Washington, DC, August 29, 2019. (Photo by SAUL LOEB / AFP)        (Photo credit should read SAUL LOEB/AFP/Getty Images)
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Donald Trump is once again toying with a plan to cut capital gains taxes without passing a bill through Congress. The idea appeared to be dead last week, when the president told reporters that it was too “elitist.” But on Friday morning, Trump tweeted out an op-ed by Texas Sen. Ted Cruz and anti-tax lobbyist Grover Norquist calling for the move, adding a slightly cryptic note of approval.

A White House official later confirmed to the Washington Post that, yes, the tax-cut-by-executive-fiat is back on the table.

Here’s the scheme: Today, Americans pay capital gains taxes on the difference between the price of an asset when they buy it and when they sell it. Under the plan Trump is considering, investors would get to adjust the purchase price of their stocks, bonds, and such for inflation—which tax wonks call “indexing.” So, let’s say you bought $100 worth of shares in the Acme Explosives Corporation ten years ago, and sold it for $150 today. Under current law, you would owe taxes on the full $50 profit. With indexing, you would only have to pay taxes on a $31 profit, because your purchase price after accounting for inflation would be $119.

Congress would never pass this sort of change since Democrats have no particular interest in offering a freebie tax cut to investors. But the White House believes it can use its regulatory power to rewrite this part of the tax code—which could potentially cost $100 billion over a decade—without any help from Congress anyway. As I wrote last year when the administration first started murmuring about doing this, it is not at all clear such a move would be legal. It would also be a giveaway to the rich with little benefit to the economy (hence Trump’s short-lived “elitist” concern).

But don’t take my center-left word for it. For a little perspective, I called up Kyle Pomerleau, chief economist at the conservative-leaning Tax Foundation. “What they’re doing, which is indexing just capital gains, I don’t think is a good idea,” he told me. Here are four of his big reasons why.

1. The administration’s plan is intellectually dishonest

Defenders of indexing, like Cruz and Norquist, claim that it’s a matter of fairness. If an investor buys stock, and its price only keeps up with inflation, they aren’t really getting any richer, and shouldn’t be taxed as if they are. Pomerleau thinks that argument makes some sense. “In principle, if you want to tax income—and this is the traditional Haig-Simons definition of income— real income is what you want to go after,” he said. “It should be after you account for any inflation.”

The problem is that Republicans aren’t really being intellectually honest on this issue, Pomerleau said. There are lots of other parts of the tax code that it might make sense to index for inflation, some of which could raise taxes on investors. But the White House isn’t trying to address those—it’s just trying to enact a tax cut by fiat. “It would easier to defend if they said ‘we want to index everything because we think inflation interacts with the tax code and that’s unfair,’” Pomerleau told me. “But that’s simply not what they’re doing.”

2. It opens up new loopholes in the tax code

Tying capital gains to inflation without addressing other parts of the tax code could also create new loopholes that let investors reduce their IRS bill. “You get into the issues of tax arbitrage or tax avoidance,” Pomerleau told me. For instance: Investors might be able to game the tax system by buying stocks or bonds with borrowed money. In theory, they could earn real income, but pay zero in taxes—or even claim a loss—because their capital gains were indexed, but not their deductions for interest payments. “That is a significant issue with their specific proposal,” Pomerleau said.

3. It mostly benefits the wealthy

In their op-ed, Cruz and Norquist try to imply that indexing would help middle class families, including “the 55 million Americans who own a 401K.” This is a bit silly. Stock prices could go up slightly. But 401K withdrawals are taxed as ordinary income, not capital gains, meaning the proposed inflation adjustment won’t affect them. More broadly, just about every analysis has found that the benefits of indexing would overwhelming accrue to affluent households. That includes the Tax Foundation’s work. “We’ve done a distributional analysis of indexing, and the vast majority of the tax cut would go to the top one percent of tax payers,” Pomerleau said. Whether or not that bothers you, he told me it’s simply not correct to pretend indexing will do much for the typical American.

4. It won’t help the economy

Economists from the left, right, and center often clash over whether tax cuts will lead to more economic growth. What’s interesting about indexing, though, is that there’s very little disagreement at all; the consensus seems to be that the move would do just about jack for the economy. The down-the-middle Penn-Wharton Budget Model, for instance, predicts that indexing would lead to “roughly zero net additional economic growth” over the next ten years. The Tax Foundation thinks it would increase the longrun size of the economy by about one-tenth of one percent.

This analysis was a bit surprising to me, given that the Tax Foundation has produced some very bullish predictions about how corporate tax cuts would impact the economy. But as Pomerleau explained, the think tank believes capital gains cuts are less effective at spurring growth for a variety of reasons. They might give Americans slightly more incentive to save. But a huge share of stocks are already held in 401Ks or by nonprofits, which are shielded from capital gains taxes. And investors who do choose to save more might decide to invest their money in foreign assets—say, German bonds—rather than in the U.S. At the same time, cutting capital gains taxes won’t tempt any foreigners to invest in the United States, since they don’t pay taxes here anyway. Indexing would be especially ineffective at encouraging more savings and investment, Pomerleau said, because inflation is pretty low, meaning individuals aren’t getting that big a marginal tax cut—even if the aggregate budget cost of the move is pretty steep. “I am skeptical that this proposal would provide a large benefit to the economy,” Pomerleau said. Again, take it from the conservative.