Suppose that you bought $100 worth of stock 20 years ago. Suppose further that you were lucky as well as shrewd, and you were able to sell it yesterday for $400. According to the present tax law, you made $300. But wait a minute -- there has been inflation over those 20 years, and that $100 in 1966 has the same value as $335 now. Your real capital gain is only $65, the increase over $335. Should you be taxed on the paper profit of $300, or the real profit of $65?
*Taxation of capital gains is one of the most interesting and substantial of the questions facing the congressional conference when it sits down next month to reconcile the two versions of tax reform. The House bill cautiously continues the present practice of taxing only a fraction of capital gains -- but it's the same fraction whether you bought the stock 20 years ago or six months ago. That's clearly wrong. The much more radical Senate bill abolishes the special break for capital gains altogether, and that's right. The principle here is that all income should be taxed equally. But it's unfair to tax gains as though there had been no inflation over the years.
So should you be completely protected against all the effects of inflation on your investment? Not quite fully. As a long-term investor you have had a significant advantage that you ought to pay for. If you had put your money into a savings account, you would have had to pay taxes on the interest every year as it compounded. But other kinds of investment, such as stocks and real estate, appreciate untaxed until you choose to sell. You owe the government, in effect, the interest on those deferred annual taxes. To compensate, the tax law ought to give you only partial rather than complete adjustment for inflation.
The case for fully taxing capital gains, you notice, rests on the idea of fairness rather than on economic theory. Some economists -- not to mention all the stock brokers -- are attacking the Senate's bill on grounds that it will damage economic growth. Without the special break for capital gains, they argue, people will stop investing and industry will strangle for lack of capital.
But will that really happen? The experience of the past decade suggests that the broad trends of investment and growth are not greatly affected by this kind of change in taxation. People invest because they see opportunities and think that they can make a profit. Special preferences had greater influence when the top income tax rate was 70 percent, five years ago, than they will if it falls to 27 percent, as the Senate wants, or to 38 percent, as the House bill has it. That's the whole point of the reform bill. As the rates come down, the traditional special preferences become unnecessary -- and abolishing them pays for the lower rates.