Stylized Facts and Fallacies of Capital Gains Tax Rate Reductions and Indexation
VICTOR A. CANTO AND ARTHUR B. LAFFER
A capital gains tax rate cut from the current 28 percent to 15 percent without indexing should be preferred over pure indexing if the real return on the investment exceeded the rate of inflation. With inflation higher than the real return, the preference would be for indexing. At a 20 percent capital gains tax rate, the breakpoint occurs when inflation is 40 percent the size of the real yield.
This explains why people who are after "the big kill" prefer almost any rate reduction over indexing. But we should never let the best become the enemy of the good. Our view is that, on balance, we'll get more of a capital gains tax reduction with indexing than we could ever realistically get with a rate reduction. Future congresses would be far more likely to raise rates back up again than they would be to remove indexing. As a final point, it also seems likely to us that an indexing proposal would have broader coverage than would rate reduction. 1
Whatever happens, be it rate reduction, indexing, or some combination, we all will be a lot better off. The logic underpinning any tax whatsoever on capital gains is flawed to the core. In spite of Herb Stein's exalted forum on the editorial page of the Wall Street Journal, his analogy between a basketball player earning a cool million and an entrepreneur's capital gain of a million is wrong. 2 They are not equivalent events. Capital gains is not income nor is the value of an asset income. Treating changes in the value of an asset as income is sparkle-headed. If income is to be taxed, then capital gains should not be taxed. A government can choose to tax either the value of an asset or its yield, but it should not tax both! That is double taxation.