Accountant, taxes, 1040

Larry Kudlow, the new director of the National Economic Council for President Donald Trump, wants to change capital-gains taxes by indexing them to inflation. He has raised the possibility that Trump could implement that change by executive order. Kudlow is right about the policy, but it would be a mistake for Trump to implement it unilaterally.

The capital-gains tax has always applied to both real gains and inflationary gains. But taxing inflationary gains makes little sense. It causes effective tax rates to rise when inflation does. And it means that two people who make the same real gain on their investments pay different effective tax rates if one of them holds his investments in a higher-inflation period than the other.

Say you buy stock for $1,000 and sell it for $2,000 a decade later. The tax rate is 23.8%, so you’ll pay $238 in tax on the $1,000 capital gain. If inflation has averaged 2% per year, however, roughly $219 of your gain reflects inflation and your real gain is $781. The $238 tax will be 30.4% of that real gain.

If inflation averages 3% per year, the effective tax rate would be even higher: 36.3%. You can end up paying a tax on an entirely illusory gain or even on a loss.

Indexing the tax to inflation would mean applying it only to the real portion of the gain. So, in our 2% inflation example, the tax would apply to $781 rather than to $1,000. The effective tax rate would be the same regardless of the inflation rate.

There are four chief arguments against indexing. One of them is that some other provisions of the tax code are not indexed for inflation, either. But that’s a reason to index those provisions, too, not to refrain from indexing capital gains. Three other arguments against indexing are that it would lower federal revenue, unfairly benefit rich people, and make the disparity between tax rates on income and capital gains even bigger.

Whatever force those arguments have, they can all be addressed by raising the capital-gains tax rate by enough to make up for the revenue losses that come from indexing. That way rich people would not pay less as a group, but taxes would be apportioned among them in a more rational way.

Just making the inflation adjustment would lower the average effective tax rate on capital, so Kudlow would find it more attractive than indexing and raising the rate above 23.8%. But the long decline of inflation has brought the effective rate down already. (One point of indexing would be to insure against high inflation in the future.) Holding the effective rate constant while applying it only to real increases in asset values would be an improvement on the status quo.

It’s an improvement that Congress would have to legislate. Some conservatives think that a president has the power to implement indexing without congressional approval. The debate on this point has lasted decades: Conservatives tried to convince the George H.W. Bush administration to make the change on its own, but were rebuffed by his Treasury and Justice Departments. The statute says that capital-gains taxes are levied on an asset’s sales price minus its cost; the question is whether “cost” is an ambiguous term that can mean the dollar price at which the asset was bought or the inflation-adjusted price.

The Chamber of Commerce argued back then that it was ambiguous, and that if the Bush administration interpreted it to call for an inflation adjustment the courts would be obliged to defer to the executive branch’s interpretation. But the government’s lawyers did not find it to be ambiguous at all. And anyway, the idea that courts should defer to executive interpretations of the law has been in retreat in recent years, especially among conservatives during the Obama era. So it’s not clear that the Trump administration would prevail, or should, if it went for indexing.

But let’s say that the Chamber had all the legal arguments just right in the early 1990s. The administration should still refrain from indexing by fiat. It would be a big change to a longstanding practice. It’s a change that Congress could have made at any point since this debate broke out but has not enacted. Presidents should not exploit every power the law technically gives them to usurp the role of the legislature to become, in effect, the legislator-in-chief.

President Trump should instead ask Congress, which his allies still control, to legislate the change. Indexing capital gains is a good idea, but it’s not one worth further warping our constitutional order.

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Ramesh Ponnuru is a Bloomberg View columnist. He is a senior editor at National Review, visiting fellow at the American Enterprise Institute and contributor to CBS News.

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