President Bush has given no quarter in flogging congressional Democrats over the budget deficit. Yet as the Gramm-Rudman deadline loomed over negotiations, the key sticking point remained his insistence on a tax cut. The president picked the wrong time to dig in his heels on lowering the capital gains tax rate.In fact, as the Oct. 1 deadline grew near, it was the Bush forces that blinked, and the result may be a reasonable compromise on capital gains: indexation. So long as the revenue loss from capital gains tax relief is made up elsewhere, and so long as already glaring tax inequities are not aggravated, this is a fair outcome.
The last major tax code overhaul left the rate on capital gains - increases in the value of stocks, real estate or other assets - the same as on ordinary income. Previously, the capital gains rate had been half the ordinary rate. Most upper-income taxpayers now pay 28 percent on wages and capital gains.
Historically, the capital gains preference rested on an incentive argument. It was supposed to encourage investment in lieu of consumption and therefore spur general economic growth. With the dramatic fall of top-bracket tax rates, the incentive value of a discriminatory rate fell as well. Moreover, the inherent class inequity of the capital gains preference grew even more glaring.
True, many staunchly middle-class Americans - and especially retired wage earners - record capital gains. When the tax falls on a long-held asset, such as the family homestead, it can seem unfair indeed.
Still, it is the very rich who have the largest stake in capital gains. Two-thirds of this income goes to people with incomes over $200,000. And many of their appreciated assets fail the test of social utility. Why should the tax code encourage investments in Palm Beach villas, diamond jewelry or indeed in baseball cards? As an incentive, the indiscriminate capital gains preference is a blunt instrument.
Indexing capital gains to offset the effects of inflation, on the other hand, is absolutely defensible. Stock that appreciated 50 percent during a period of 50 percent inflation should be seen as producing no taxable gain.
Democrats have set their price for indexation as approval of an upper bracket tax increase sufficient to cover the revenue loss from indexed capital gains. That's only fair. For the president to insist otherwise would be to feed the deficit he deplores.