It's a Good Time to Index Taxes On Capital

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The Modeled Behavior blog has been taking nominations for the 4% Club, which it describes as "An elite group of economists, pundits, and politicians" who want the Federal Reserve to raise its inflation target from 2%. Its members tend to the left side of the political spectrum, but not exclusively; one of the loudest champions of a higher inflation target is Scott Sumner, a right-of-center economics professor at Bentley University.

Some of the four-percenters have expressed annoyance and consternation about persistent inflation-hawkishness at the Federal Reserve, even in light of a TIPS spread showing 10-year inflation expectations below 2% -- far from raising the inflation target, the Fed is not even managing to hit the target it has. To understand this behavior, inflation proponents have tried to psychoanalyze the Fed, including Sumner's argument that it is engaged in "opportunistic disinflation" in an explicit effort to undercut the 2% target.

But one likely barrier to a higher inflation target is a quirk of tax policy: non-indexation of capital taxation means that higher inflation causes a stealth rise in the real tax rate on capital gains and interest income. Naturally, this makes investors more keen on rock-bottom inflation than they otherwise would be -- and the Federal Reserve Board is institutionally likely to focus on the interests of the investor class.

Congress will certainly pass a major tax bill this year to stave off the full expiration of the Bush tax cuts. Including the indexation of capital taxes in that package would both improve incentives to invest, and give the Fed a freer hand to choose an inflation target without reference to capital gains tax effects. It would also help offset the pain from a likely rise in the capital gains tax rate from 15% to 20% for high-income filers.

Inflation has large impacts on the real capital gains tax rate. To understand why, consider an investor who buys an asset for $100 and earns a 40% real gain over seven years. In a world of 2% inflation, the investor's nominal gain is $60.82, and he pays $9.12 in capital gains tax at a 15% nominal rate; this is a 19.9% effective tax rate on his real gain of $45.95 (equivalent to $40 at the start of the investment period).

But if the inflation rate had been 4%, the nominal gain would have grown to $84.23 and the real tax rate to 24.0% -- a 21% relative increase in the tax rate. This effect would be even larger if the real rate of return were lower, meaning the inflation penalty on capital gains grows when inflation is high or when asset markets are anemic.

Alternatively, you can think of our current capital gains tax as a combination of two taxes: a 15% tax on real returns to capital, and a wealth tax on asset holdings with a rate equal to the product of the capital gains tax rate and the inflation rate. Where inflation is expected to be 2%, investors can expect a wealth tax equal to 0.3% of principal; if the inflation rate doubles, so does the wealth tax, to 0.6%.

The effects are similar for taxes on interest income: the interest on a bond is a combination of real income, and nominal income that merely offsets inflationary reductions in the value of bond principal. Again, you can think of the portion of the tax that applies to the non-real portion of income as a wealth tax; but this time, the wealth tax rate is the product of the inflation rate and the ordinary income tax rate, which is often more than double the capital gains rate.

The upshot of these effects is that owners of capital have additional incentives to support a policy of extremely low inflation, apart from the direct effects that inflation would have on their holdings. If holders of capital have influence over the Federal Reserve Board, this puts a thumb on the scale against a higher inflation target -- or even gives the Fed good reason to be pretty sanguine about falling below its existing target.

Aside from distorting people's preferences about the inflation rate, non-indexed capital gains taxes are economically inefficient. We tax income in an effort to finance the government in accordance with ability to pay. But when you tax wealth instead of income, you create incentives for people to consume instead of invest. And if you were going to have a wealth tax (France has an explicit one) there is no plausible reason to link the tax rate to the inflation rate, as our system implicitly does.

A Treasury Department commission proposed full indexation of the tax code to inflation back in 1984, in the discussions that ultimately led up to the Tax Reform Act of 1986. However, while brackets for ordinary income were indexed to inflation in that law, indexation for capital income did not make it through the legislative meat grinder -- partly because, as Alan Blinder recounts in his book Hard Heads, Soft Hearts, beneficiaries of interest expense deductions would have faced higher tax bills.

But 2011 would be a good time to revisit indexation. First, this could help offset the negative economic effects from the likely rise in the top capital gains rate from 15% to 20%: taxpayers would face higher capital gains tax rates, but they would know that they are protected from tax on inflationary gains. Also, low inflation makes this an opportune time to introduce indexation, as the revenue loss from indexation is linked to the inflation rate, and would therefore be lower than usual.

The fiscal impact of indexation could be reduced by applying it also to the deduction side of the tax code, notably including the mortgage interest deduction. This would mean that only the portion of home mortgage interest in excess of the inflation rate would be deductible. Again, low inflation rates make this a politically opportune time for such a reform, because the near-term effect on tax bills would be small.

The frustration of the 4% club also offers an opportunity for a left-right coalition on indexation: conservatives who are principally concerned about arbitrary capital taxation, and liberals who mostly want to remove a political impediment to a higher inflation target.

If the four-percenters are right that modestly higher inflation would lead to greater real GDP growth (and I think they make a strong case) then it's hard to see why owners of capital would stand in their way, absent excellent tax reasons to want inflation as low as possible. While an unexpected rise in inflation would enrich debtors at the expense of creditors, higher real GDP growth would make everybody better off, and so the policy choice is not zero-sum.

Most of the tax changes to come in 2011 will be no fun; closing a fiscal gap never is. But indexation of capital taxes could provide a bright spot in an otherwise-gloomy tax bill, no matter which side of the aisle you look at it from.

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute.

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