Fund infrastructure by popping the inflation tax

President Trump and congressional Democrats last month pledged to commit $2 trillion in infrastructure projects over the next decade. The slight problem they face? No one has any idea how to pay for it. Neither party wants to run up more debt. Republicans are opposed to higher taxes. Democrats are opposed to spending cuts. What to do

One idea is for the Treasury Department to remove inflation from the capital gains tax, something legal scholars believe could be done by regulation. Known as “capital gains indexing,” the idea is simple: Instead of a capital gain being defined as what an asset is sold for minus what it is bought for, it could instead be defined as what an asset is sold for minus what it is bought for plus inflation since purchase.

Take, for example, a home sold for $500,000 and purchased for $100,000. Under the current tax rules, the capital gain is the difference between these two numbers, or $400,000. But suppose our homeowner was allowed to index his $100,000 basis to inflation, which brings his basis up to $200,000. In that case, his gain is only $300,000 — the sales price of $500,000 minus the inflation-adjusted purchase price of $200,000.

The Tax Foundation in a report last year calculated that fully one-third of the unrealized capital gains on all assets held by households were merely the result of inflation. If taxpayers were permitted to inflation index their asset basis, the result would be the equivalent of a one-third cut in the capital gains rate.

Cuts in the capital gains rate of that magnitude would likely result in an “unlocking effect” of assets. How large could this be? According to the Federal Reserve, families own nearly $30 trillion of real estate, most of it owner-occupied. They own $18 trillion of stock and $6 trillion of mutual funds in taxable brokerage accounts.

The magnitudes are nearly as staggering for corporations. They own $13 trillion of real estate and $2 trillion of stock. Partnerships and LLCs, for their part, own over $13 trillion in real estate.

Adding together households, corporations, and unincorporated firms, that’s almost $100 trillion in assets, the majority of which is in residential and commercial real estate. If even a fraction of those assets are sold as a result of more neutral tax treatment and the resulting capital gains are taxed (currently at a 23.8% rate for individuals and unincorporated business owners, and a 21% rate for corporations), there might just be enough money to finance an infrastructure project the size Trump has called for.

That’s not all. The act of unlocking these assets will themselves help the infrastructure effort. If a warehouse is sitting in a bad part of town, giving the longtime corporate owner an inflation-neutral reason to sell will help facilitate putting in a new power plant on the property, or whatever is a higher and better use for that space.

Because the Treasury Department can remove inflation from the capital gains tax by regulation, there’s no congressional hurdle to overcome and no score to worry about. To the contrary, moving to a fair and neutral inflation adjustment on capital assets will be a revenue windfall to the federal government. This isn’t just true because it’s a capital gains tax cut, although that has produced revenue windfalls every time it’s been tried, but because many of these assets were never going to be sold absent this policy change. People change behavior when tax rules change, and removing inflation from the capital gains tax will be no different.

Congress is not likely to pass any meaningful pro-growth legislation between now and Election Day 2020. Nor is Congress likely to find traction on an infrastructure bill. Trump can make both happen entirely on his own, and he’d be smart to do so.

By Ryan Ellis

2019-05-15T19:23:55+00:00May 15th, 2019|0 Comments
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