President Reagan did the economy and ordinary Americans a huge favor by indexing the individual tax code to inflation. This Tax Day, President Trump can finish the job by doing the same for the capital gains tax.
The capital gains tax, which is applied to the appreciation of assets and securities, remains at its Obama-era rate of 23.8%. It exacts a painful toll on small-business owners, who otherwise have much to celebrate this Tax Day with a new 20% small-business tax deduction and lower tax rates associated with recently passed tax cuts.
The capital gains tax hits small businesses at every phase of their life cycle. It reduces their access to credit — the lifeblood of small businesses — because it distorts investors’ risk-vs.-reward trade-off. It sticks small businesses with big tax bills for appreciating assets such as real estate. And it punishes business owners looking to sell for their success and growth.
What’s worse is that the capital gains tax not only applies to value appreciation but also to the phantom gains associated with inflation. As a result the real capital gains rate is closer to 42.5%, according to an analysis by the Tax Foundation, roughly double the stated rate.
An example from the franchise world helps make the point. Consider a franchise purchased in 1999 for $500,000 and sold in 2018 for $1.5 million. Under current law, the $1 million in profit is subject to a 23.8% capital gains tax, totaling $238,000.
But a portion of that $1 million is not value appreciation but simply inflation. According to a commonly used measure of inflation, $500,000 in the year 1999 is worth about $750,000 today. In reality, then, the value of the franchise didn’t triple as current law states, but merely doubled in real terms. Adjusting the capital gains tax for inflation would reduce the tax bill to $178,500 — a 25% savings.
Small-business owners shouldn’t be taxed on inflation for the same reason that President Reagan realized ordinary Americans shouldn’t be taxed at a higher tax bracket due to cost-of-living adjustments in their paychecks. President Trump can finish what President Reagan started by passing an executive order directing his Treasury Department to only collect capital gains tax from real asset-value increases and ignoring inflationary gains.
Former Treasury economist Gary Robbins estimates that indexing capital gains to inflation would be the equivalent of a 25% capital gains tax cut. Such a tax cut would unleash an economic boom as investors and business owners realize their capital gains and make new investments with their proceeds.
Robbins estimates this economic stimulus would boost GDP by about $500 billion and create 400,000 new jobs. Retirees and ordinary investors would see their portfolios appreciate, and they would face a lower tax burden when cashing them out.
The catalyst for this executive order may be the addition of Larry Kudlow to President Trump’s inner circle as national economic advisor. Kudlow has long championed fixing this oddity in the tax code. There’s someone even closer to Trump who has even introduced legislation to this effect: Vice President Mike Pence, who put forth legislation in 2006 to index capital gains to inflation for assets held for at least three years.
As small businesses look for policy victories in 2018 to build off 2017’s successes, they should set their sights on this potential executive order to address the quirk in the capital gains tax. This would deliver small businesses major tax relief and continue President Reagan’s legacy.
Motta is the chairman of the Coalition of Franchisee Associations, which is part of the Job Creators Network’s Coalition of Associations.