Two issues lie at the center of a trade-off that could help break the long logjam over the tax component of a federal budget agreement.
One is the indexation of capital gains, and the other is a plan to limit tax deductions for upper-middle-income and wealthy individuals.
Neither measure is the first choice of the negotiators who are trying to wring $500 billion out of the deficits projected over the next five years, but together the proposals are being weighed as possible second choices.
Bush administration bargainers have said they could accept the indexation of capital gains, which would adjust, for tax purposes, the purchase price of an investment for inflation as an alternative to an outright cut in the capital gains tax rate. This would reduce the base amount of investment profit taxed and cut investors' tax burden.
Proponents of the measure say it would encourage risk-taking, partially offset the double taxation of corporate dividends and stimulate the economy. Its opponents say that the change would favor the wealthy, reward old money and give twice as much benefit to real estate as to corporate stock.
To understand how indexation would work, consider an investor who purchases $1,000 worth of stock and sells it after 10 years for $2,191, realizing a capital gain of $1,191. Under current law, that money would be taxed at the same rate as earned income. An investor in the highest tax bracket would owe $334 in taxes.
Under indexation, the purchase price would be adjusted for inflation. If inflation averaged 4 percent a year, the adjusted purchase price would be $1,480. The taxable gain would only be $711, and the same investor would owe only $199 in taxes.
The indexation of capital gains "may be marginally better than an across-the-board capital gains tax cut," said Harvard University economics professor Lawrence Summers, but he said that indexation would "encourage arbitrage for tax shelters" and would "disproportionately benefit old capital versus new investment." He added that "indexing would do nothing for venture capital."
Even some Bush administration allies who support a capital gains tax rate cut are lukewarm about the idea of indexation. "Indexing does not do much to reduce capital costs and does not do much for promoting entrepreneurship," said Mark A. Bloomfield, president of the American Council for Capital Formation, a lobbying group that has championed cuts in the capital gains tax.
Bloomfield noted that since most entrepreneurs invest sweat and ideas, they do not make the kind of investment that can be adjusted for inflation. Investors in the stock market would benefit more, he said.
To mollify critics who say indexation would give a break to old investments rather than encourage new ones, the administration negotiators have suggested making indexation effective only for investments made after passage of a budget agreement. That change also would sharply reduce the cost to the Treasury over the next five years.
But Democrats say that over a number of years, the loss of tax revenue to the Treasury because of indexing would be greater than the loss under a cut in the capital gains tax rate. They also have said that indexation does nothing to make the tax code more progressive. "The question is still: Will the wealthy share in deficit reduction," said one congressional aide.
Searching for ways to make the tax code more fair, Democrats have turned to variations of a proposal by Rep. Don J. Pease (D-Ohio), which would limit tax deductions for upper-middle-income and wealthy individuals. Pease said it would raise $54 billion over five years, but it is a complex proposal that would eliminate a portion of the deductions for individuals whose incomes exceed certain thresholds. The amount eliminated would equal 10 percent of the difference between the individual's income and the threshhold.
For example, take a couple that earned $160,000 a year and has $40,000 in itemized deductions. If the threshold were set at $100,000, then the proposal would set a deduction "floor" equal to 10 percent of the difference between the threshold and the couple's income. Since the difference is $60,000, the couple would be unable to take 10 percent of that amount -- or $6,000 -- in deductions. The remaining $34,000 in deductions could be taken, and there would be no ceiling on that amount.
Pease wants the threshold set at $50,000 for individuals.
The size of the tax could be changed by altering the thresholds or the percentage of disallowed deductions.
Pease said he believes it would address the concerns of many charities, construction interests and others concerned about deductions because it would not discourage people from making new deductions once they had deductions in excess of the disallowable floor. Most homeowners would fall in that category.