The Partiality of Indexing Capital Gains
[A paper presented at 1990 Annual Conference,
National Tax Association, San Francisco, 11-14 November 1990.
[published in proceedings of the 83rd Annual Conference on Taxation of
the NTA-TIA, Columbus, Ohio, 1991, pp. 49-53]
In 1986 Congress made realized capital gains fully taxable, in the
spirit of uniformity animating the 1986 reform. The effect on gains
taxes was largely offset, to be sure, when Congress lowered the top
rate from 50% to 28%, abandoning 70 years of rate progressivity.
Congress also lowered the corporate tax rate. Nonetheless, the change
did overturn a long tradition of excluding half or more of gains from
taxable income. No special concern was shown for the phantom income
element in nominal capital gains.
Now we are witnessing a major effort to revive the exclusion of part
or all of capital gains from taxable income, partly on the grounds
that much of the gains are "phantom" income, an illusion of
inflation. President Bush is the most visible champion. In his 1988
campaign, relief for capital gains was nearly the only specific plank
in the domestic platform. As President he has focused intensely on it
for nearly two years, to the point of jeopardizing his relations with
Congress. With troops in the Persian Gulf he still accepted a risk of
having no budget, and shutting down domestic government to win the
issue. Nearly two years of prior negotiations had stalled on this one
The President is not doing this alone. In October 1990 he announced a
willingness to bend on capital gains, only to be> reversed by his
supporters and forced into a politically dangerous acceptance of
higher tax rates, to win a small concession for capital gains. He and
his supporters carried it so far as to risk serious electoral losses
in November, 1990. This is a concerted, sustained drive by intensely
focused people willing to take heavy losses to win the one point. The
token preference they finally won this year is of value mainly to
differentiate gains from ordinary income, to prepare the way for later
efforts. They have shown staying power; so has the other side. The
contest is as old as income taxation, and is to be perennial.
The issues are distributive, allocative, and macroeconomic. The
distributive issue is clear, as issues go, and (for most people)
argues against excluding gains from tax. There is little substantial
dispute that the proximate benefits of lowering the rate on gains
would be highly concentrated. The dispute focuses on subsequent
macroeconomic effects: supply-side kick, and demand-side stimulus.
The allocative issue is not much stressed. A tax on realized gains
has some "locked-in effect." If the issue were pushed, the
answer would be that the locked-in effect results mainly from step-up
at death, rather than from a high rate per se. The macro issues are
capital formation, and raising investment. The case for lowering gains
taxes is made mainly in those terms, and we will treat it likewise.
This case is a major expression of what its champions call "supply-side
economics," coupled with traditional demand-side stimulus from
Spokesman Paul Craig Roberts writes the tax on capital gains is
simply "pandering to envy," and will abort capital formation
at the expense of the general welfare. The Marxist historian Maurice
Dobb, with a different emphasis, has also attributed capital
accumulation to fortunes made by holding land for the rise.
[Maurice Dobb, 1947, Studies in the Development of
Capitalism, New York: International Publishers, at pp. 179 ff.]
We surely agree with Roberts et al. that domestic capital formation
is a crying current need; and the means is to foster saving and
investing (but properly defined, as below). We also agree there is a
strong, bi-partisan case for raising investment flows of the
income-creating, work-activating kind. Here, however, we meet the
problem of distinguishing new capital from old assets, especially
Land is not formed, like capital, by saving and investment; land is
not reproducible. For that very reason land tends to appreciate, and
therefore has to be a major source of what are misleadingly called "capital"
gains. Again for that very reason, there is no supply-side kick in
untaxing gains. Most of them are land gains, and should be called
that. To use land as a store of value is macro-economically
unproductive at best, and on balance counterproductive and
destabilizing (considering its effect on financial institutions like
To handle this matter we need two semantic distinctions which often
are lost in the word-fencing of debate. Walter Heller, whose policies
still enjoy bi-partisan support, thought and spoke in a Keynesian
framework where "investment" means "investing," an
affirmative, job-making action. It is a process, not a store of value;
an economic flow, not a fund. It is not the asset held: this "investment"
is a noun, macro-economically static and sterile.
[Land may appreciate, and one may call this "investment,"
but the appreciation employs no one and creates no new wealth
(although it may reflect the externalities of wealth created by
To signalize these differences I use the present participle "investing,"
rather than the ambiguous noun "investment."
[Webster's 9th New Collegiate defines investment
both ways: it is an action, (the Keynesian usage); it is also an
asset being held, a store of value. Such a two-faced word is a
natural medium for double-talk, and has been so exploited, to the
detriment of general understanding.]
Every Keynesian also knew in 1961 that investment means net,
positive-sum investing. It does not include buying and selling
existing assets like land: these are zero-sum transactions,
macro-economically non-functional and barren. [Keynes, although
careless of consistency, generally took care to distinguish old and
new assets. " ... the competition of a high interest-rate on
mortgages may well have had the same effect in retarding the growth of
wealth from current investment in newly produced capital-assets as
high interest rates on long-term debts ... "
[General Theory, 1936, p. 241. The old
macro-economists generally refer to investing in newly produced
assets as "income- creating expenditure," which is clear
and correct, but too much of a mouthful.]
I use "investing" only in the sense of net,
income-creating, job-making spending.
[Note the difference between real turnover and mere
ownership turnover. Ownership turnover generates no income (except
for brokers and M&A personnel) and creates no capital. Real
turnover also creates no capital, but does forward supplies of goods
to consume, and flows of investing to produce replacement goods.
Most of gross investing is reinvesting funds received or anticipated
from sales of old capital (including inventories, which turn fast,
and "fixed" capital which turns slowly as it depreciates
and the funds are reinvested).]
As to borrowing on land, that can be worse than barren when the
financial system rises and falls on a land bubble, as it has and is.
Heller and his contemporaries also knew that the incentive driving
job-making investing is MRORAT, the Marginal Rate of Return after
[Economists of the 1960s, following Keynes, called
it the MEC, or "Marginal Efficiency of Capital," an
awkward phrase now little used. Awkward or not, and intended or not,
it had great historical consequence by putting the emphasis where it
belongs, on marginal rates of return, excluding rents.]
The marginal idea is pivotal. The Average ROR includes rents; the
Marginal ROR is the pure return to new investment, Keynes' "inducement
to invest," which is activating and functional.
These Heller ideas were invoked again by supply-siders in early
Reagan times. However, policy over the course of the 80s lost the
substance of that policy, keeping only the guise. Domestic leaders
forgot the usage of "investment" in macro-economics.
They gradually slipped into an illusion that buying and holding and
bidding up old assets like non-reproduceable lands and stocks would
make jobs and produce goods. They forgot to distinguish old from new
assets, and marginal from average returns on investment (average
returns, recall, include rents). Both critics and supporters of "supply-side"
policies now darken counsel by debating current policies in
supply-side terms, when the terms no longer describe the policy at
Along with normal confusion, there is intelligence behind such error.
The case for downtaxing gains depends in part on exploiting confusion,
in order to pass off rent-raising as an incentive for saving and
investing, and so to disguise its non-functionality and eminent
taxability. The policy is called "supply side," but isn't.
The litmus test of the sincerity of capital-formation champions is
their treatment of irreproduceable land. Raising rents and land
prices, and protecting the gains from taxation, is purely
distributive, with no power to foster saving and investing. On the
contrary, a higher share for rent and/or land purchase must mean a
lower share for the investor in new capital.
Ignoring land and its distinctive attributes has the effect of
treating land as though it were true, reproduceable capital, to be
formed by saving and investing, to be routinely worn out and replaced
in the normal course of life and business. It lets advocates of
investing and capital formation abuse the legitimate case for macro
incentives, exploiting the case to camouflage unearned, nonfunctional
rents and increments to land value.
[Brookings' major contribution to our subject is
Henry Aaron (ed), 1976, Inflation and the Income Tax, with chapters
by 15 eminent economists. Land is treated by none and is not in the
index. [It is mentioned in passing only by one, George Lent.]]
Tantamount to ignoring land is minimizing its weight. Thus one may
acknowledge it indulgently, while actually dismissing it. In fact,
though, land comprises some half the assessed value of taxable real
estate in California, and is not dismissable. Half the assessed value
means more than half the market value because of assessment
discrimination favoring land. A raft of studies of assessment
discrimination, like the sales/assessment ratio studies of the U.S.
Census, show consistent patterns of discrimination favoring land. In
addition to ordinary assessment discrimination there is much
legislated underassessment, for land in forest, farm, country club,
and other favored uses. [An interesting recent case involves Charles
H. Keating, Jr. of Arizona. He and Kemper Marley posed as farmers to
secure "millions of dollars in agricultural tax breaks on land
they planned to develop." The breaks result from lower assessed
land values for "farmers."
[Steve Yozwiak, "Land-tax bill OK reached,"
The Arizona Republic, 13 April 89.]
Most states legislate similar loopholes, widely used by suburban land
speculators. More generally, the effect in California of Prop. 13 is
to keep much land assessed not much above its 1978 valuation.] If that
data were not enough, most of us resident in California have been
through one or more years since 1976 when the value of our homes alone
rose by more than our annual salaries.
[As early as 1970 it was possible to document a high
share of land value in national wealth: Mason Gaffney, 1970, "Adequacy
of land as a Tax Base," in Daniel Holland (ed.), The Assessment
of Land Value, Madison: University of Wisconsin Press, pp. 157-212.
The theme is further developed in the writer's "Why Research
Farmland Ownership and Values?", 1985, in T.A. Majchrowitz and
R.R. Almy (eds.) Property Tax Assessment, Chicago: U.S.D.A.,
I.A.A.O, and The Farm Foundation, pp. 91-109.]
Considering the true nature of most "capital" gains, it is
not surprising that economists have not come forward with claims of
large macro benefits from untaxing gains. The CBO, using a Washington
University Model, recently estimated that excluding 30% of gains from
the income tax base would raise GNP by only "0.1%" - a
number well below the accuracy of any macro model, and effectively
zero. James Poterba last year came up with another figure near zero.
[Reported in Business Week, 24 April 89, p.20. [My
copy of Poterba's monograph has apparently self- destructed.]]
Poterba stresses the effect of portfolio substitution. So does John
Muellbauer of Nuffield College, Oxford.
[John Muellbauer, 1990, "The Great British
Housing Disaster," ROOF, London: Shelter, May/June.]
Land value, like slaves and government bonds, meets the security need
of asset-holders without their having actually to create capital. High
land values doubly check saving. First, by rising they look like
individual income and encourage more drafts on the flow of consumer
goods, without adding to supply. Second, once risen, they satisfy
portfolio demands in lieu of real capital. British policy-makers take
some heed of such wealth effects but, according to Muellbauer, look
only at paper assets and err by overlooking land values.
Regardless of the several points above, many economists are bent on
relieving capital gains from taxation. Faced with mighty political
forces in collision, mainline economists have brought forth a
compromise technical fix: indexing capital gains. Alan Blinder, a
moderate and intelligent conservative, is a prominent spokesman. The
late Joseph Pechman, a moderate and intelligent liberal who long
championed taxing capital gains, wrote last year that "economists
agree" that indexing is the way to go. When the dean of
Haig-Simons boosters concedes so much, indexing would indeed seem to
be the consensus position. At times Congress and the President have
been close to seizing on indexing as a viable compromise, and may
finally do so one day.
The idea is to step up the basis of capital assets by the same
percentage as the price index rose over the period of ownership,
before deducting the basis from sale price to determine taxable gain.
[There has been little discussion of what index to
use, and it is not our topic. It is a major problem for indexers.]
The purpose of this indexing is, of course, to remove "phantom
income" from the tax base.
Why remove phantom income from capital gains, and not from other
property income? William Vickrey often points out that all assets, not
just capital assets, are "taxed" by inflation. Inflation
with an income tax is in effect a general wealth tax. Monetary assets
are surtaxed in the obvious way, and equity assets (both capital and
ordinary) are surtaxed when they or their products are sold, because
of the phantom income they generate. Thus, if one favors a general
wealth tax (many people do) taxing phantom income is a way to achieve
a desired goal. [In today's atmosphere we forget how recently it was
learned, respectable and progressive to favor taxing property,
especially rents and unearned increments to land value.
After World War II a whole generation of development economists
toured the Third World promoting forms of property taxation. One
result was the Punta del Este Charter. Its ancillary Santiago
Conference on Fiscal Policy of December, 1962, sponsored by OAS, IADB,
and ECLA, pushed for no less than five kinds of high taxes on
property: on gains, on net wealth, on urban and rural property,
surtaxes on property income, and inheritance taxes.
["Tax Reform is Major Objective of Alliance in
Latin America," International Commerce, 4 Nov 63, pp.14 ff.]
International agencies were pushing land reform and property taxation
around the whole Third World. The east coast of Asia responded,
especially the "four tigers" of Taiwan, Hong Kong, Singapore
and Korea. If the policies have tended to suppress enterprise and
capitalism one is hard put to explain the extraordinary capitalist
development of the four tigers which tax property heavily, and the
stagnation of Latin America which does not.
Lloyd George, when Chancellor of the Exchequer under Herbert Asquith
in 1909, proposed a huge peacetime budget increase "to wage war
against poverty." (He was also financing a naval race.) He
included not just a small national land tax, but a tax on land gains,
and a surtax on income from land.
William Howard Taft and Woodrow Wilson presided over the birth of the
American income tax. Wilson's second Congress, elected in 1914,
contained the craftsmen. The first substantial application of the 16th
Amendment was in 1916, the law being designed by Congressman Warren
Worth Bailey. Bailey shaped the law to meet the demands of the time
for, and his personal belief in, special taxation of unearned incomes.
He was a leading "single-taxer" as they were then miscalled,
a champion of taxing unearned increments. The idea was merged into
The Wilson administration Treasury even moved to tax gains as they
accrue, a principle later endorsed by most tax economists following
Professors Haig and Simons and others. The USSC, however, ruled that
Congress must authorize such taxation explicitly (Eisner v. Macomber,
1920). Congress, by that time heavily changed following the Palmer
raids and deportations delirium of 1920, declined. With the end of the
Cold War (which dates back to then, in its influence on domestic
ideology and policy), may we not now expect a revival of
We are not pushing for a general wealth tax, but for impartiality and
accurate thinking about indexing capital gains, a policy that would
protect some forms of wealth, but not others. This apparently
temperate, common-sense proposal is in fact partial and
discriminatory. Worse, it protects most where the macro social
benefits are least.
Holders of monetary assets and recipients of fixed incomes are the
primary victims of inflation. Holders of depreciable capital pay the
inflation tax on phantom income that arises constantly in ordinary use
because depreciation write-off is limited to historical cost.
[It is useful to think of "fixed"
depreciable capital like an onion with concentric layers. With time
and/or use, layers are sequentially peeled off and sold to
consumers, like parts of an inventory. With inflation, each peeling
is sold for more than its original nominal cost, yielding phantom
taxable income. Actual inventories may be sheltered by LIFO
accounting; fixed capital is not.]
In contrast, ordinary cash flow to landholders contains no phantom
income because there is no depreciation. Land is only taxed on phantom
gains at the time of sale, if ever. Since taxable ownership turnover
is very slow, about 2-3% per year, land is the asset whose gains are
already most sheltered by step- up of tax basis at time of death and
devise. Land is most sheltered by deferral of tax until realization.
Indexing would simply give more shelter where shelter already is.
Land would be the asset most favored by the indexing of capital gains
under tax law. Land's basis (the value to be augmented by indexing) is
not depreciated away (except illegally); and it is the asset most
likely to appreciate with and also without general inflation.
Equities gain when inflation lowers the real value of debt. Indexing
would then additionally help the equity owners, who have already
gained from inflation, not the creditors who have already lost. Most
private debt today is secured by real estate, either directly or
through the corporate veil. These landowner-debtors who gain from
inflation are largely the same ones whom it is proposed to aid further
by indexing their gains.
An invisible creditor that loses is the United States Treasury. Most
land carries deferred tax liabilities to be recouped at time of sale.
These liabilities include deductions taken by expensing carrying costs
on appreciating land.
[Such deductions are "ordinary," and do
not lower the basis of property.]
Much of the recoupment is illusory, when these invisible debts are
paid in depreciated dollars. This is phantom recoupment: the standard
literature neglects it completely. Phantom recoupment for The Treasury
is real untaxed income for landowners. The literature is devoted to
deploring taxes on phantom income. The results are unbalanced thinking
and misleading conclusions.
There are more invisible debts to The Treasury. Under the Haig-
Simons rationale these also include taxes that should have been
collected in the past, annually, as land price rose. When unpaid taxes
are accrued in good dollars, but paid later in bad, the recoupment of
tax liabilities is only partial. Accrued unpaid tax liabilities are
the Treasury's basis in appreciating lands: it has bought into them by
deferring taxes. To index the owner's basis but not the Treasury's
basis would cheat the Treasury, i.e. other taxpayers. They are cheated
anyway, since The Treasury does not charge interest on the deferred
taxes. They are cheated again because the top marginal tax rate of 28%
is now far below the 50% rate at which most past deductions were
Although most benefits of indexing go to land, the true capital in
owner-occupied residences, and personal playgrounds, would also gain
from indexing because the basis (the deductible value to be stepped up
by indexing) is not tax-depreciable and so remains fully intact at
time of sale. Thus, indexing would add to the heavy existing tax bias
for true capital in this particular form. Interest and property taxes
are fully expensible even though the counterpart "imputed income"
(benefit of occupancy) is untaxed.
In summary, selective lightening of taxes on new investment can be
justified on incentive grounds, but indexing "capital" gains
would mainly favor old assets and assets already sheltered, notably
land. The ordinary cash flow from depreciable capital, which needs
better treatment, would not get it. The ordinary cash flow from land
contains no phantom income; landowners already benefit from phantom
recoupment of early deductions and deferrals; debtor-landowners gain
peculiarly from drops in the real value of debt. Indexing would least
relieve those most needing relief, and vice versa.
Ominously, selective indexing of gains would also create a powerful
new pro-inflation lobby. It would further enrich lobby supporters with
more discretionary funds, and give them an urgent interest adverse to
the general welfare.