The GOP's Capital-Gains Tax Hike

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Republicans are on final approach to land their tax bill out of House-Senate conference, and for the most part the winds look favorable. Yet one surprising provision in the Senate bill would gratuitously harm individual investors, and the GOP ought to eliminate this de facto increase on capital-gains taxes.

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The Senate bill creates a “first-in, first-out” requirement for investors who sell their stock investments.

Stephen Entin

at the Tax Foundation describes it this way: A person buys 100 shares of a company at $25 a share in 1990. Then in 2005 he buys a 100 more for $50 a share. Now he wants to sell 100 shares at the current price of $100. The Senate bill would force this investor to sell the older shares first, which would expose the investor to a higher tax liability on the capital gain—a gain of $7,500 versus $5,000.

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This is a lousy idea for several reasons. One is that older shares tend to have more gains, as companies grow and the market rises over time. Markets can benefit from investors who buy and hold stocks even amid the occasional correction and recession, and the Senate punishes this behavior.

Some gains on long-held shares are also the result of inflation, so forcing their sale would make investors pay taxes on those artificial gains before they might want to. Some investors also like to balance their gains in some stocks against their losses in others to minimize their tax liability. This is especially important given that investors can only write off $3,000 in losses net of gains in any one year.

More than 40 House Republicans noted in a letter last week that the move would reduce market liquidity by locking investors into shares they don’t want to hold. This could also slam retirees who cash in on investments for income or employees who are offered compensation in the form of stock.

Even worse, and this is hard to believe, the provision applies only to retail investors. The Senate language exempts sales by “a regulated investment company” such as mutual fund outfits. Vanguard, Fidelity and friends won a dispensation because they convinced Congress that the rule would be costly and inefficient. That’s true, but then why impose it on

Aunt Millie

who has held her shares in Procter & Gamble for a generation?

The answer appears to be a money grab as the Senate scrambled to stay under its $1.5 trillion fiscal limit over 10 years. But the first-in first-out provision would yield about $2.7 billion over 10 years, which is a pittance; the child tax credit expansion would cost $584 billion. The $2.7 billion estimate is almost surely wrong in any case because investors will change their behavior, and capital-gains realizations are especially sensitive to changes in tax rates.

Ronald Reagan’s

1986 tax overhaul increased the maximum capital-gains rate to 28% from 20%. Realized gains as a share of the economy shot upward in 1986, as investors rushed to cash in ahead of the higher rate. Realizations promptly fell once the higher rate hit. The reverse happened when

George W. Bush

cut the rate in 2003. And even though the increase will produce little for Treasury, “it will affect the management of several trillion of dollars of individual and mutual fund assets,” as Mr. Entin notes.

This measure will also hit many of the same folks who are losing the state-and-local tax deduction with no commensurate relief in the top income-tax rate for individuals (38.5% in the Senate bill, down from the current 39.6%). These filers tend to claim a higher proportion of their income in investment. The irony is that the bill continues to be attacked as a sop to Mr. Moneybags even as many provisions hit the 1% with tax increases.

By the way, all of this would be a mess for tax compliance, though the ostensible purpose of reform is to simplify the code. But the larger principle is that investors should be allowed to manage their own assets as they fit, which is something we thought Republicans believed.

Appeared in the December 12, 2017, print edition.

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