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A consumer price index deflator deduction.

Implementation of a consumer price index deflator deduction (CPIDD) would bring the areas of the Tax Code relating to capital gains on sale or exchange of various classes of property closer into line with the economic realities of our society.

The capital gains deduction was repealed at the time the tax rates were reduced under the Tax Reform Act of 1986. This closed a perceived (and sometimes actual) loophole viewed by the public as benefitting mostly the wealthier classes in our society. A review of the Tax Code, however, shows that Congress left most other capital gain provisions, such as carryovers, deduction limitations, separation of capital transactions for reporting processes, long-term vs. short-term, etc., intact in the tax structure. The government was "trying out" the repeal of the capital gains deduction while leaving most of the related mechanics of the calculations intact so that they could later reinstitute the deduction in some form or another.

Observation: Many members o Congress are on record indicating that the allowance of some form capital gain deduction actually increases tax revenues because taxpayers are more likely to make sales or exchanges of capital assets when they are not overburdened with related income taxes. This increased propensity to make such sales or exchanges would also serve the economy well by allowing a free flowing allocation of capital resources to areas of the economy where the capital assets are most needed. Due to past high-level inflation in our economy, older taxpayers are being discriminated against due to the creation of phantom taxable gains on properties that were purchased many years ago. This is a form of "taxflation", a tax term coined toward the end of the most recent period of high inflation.

Problem.-The problem can best be illustrated by example. Two twin brothers named "Happy" and "Sad" owned identical 20-year-old houses. They both sold their houses for $45,000 in June of 1988 shortly after a new mini-mall was completed in the neighborhood. Sad bought his house 20 years ago for $20,000. Happy bought his house in May of 1988 for $40,000. Inflation during the 20-year period equalled a total of 100%. One hundred percent inflation would mean that, economically, both brothers paid $40,000 each for their houses in today's current inflation adjusted dollars. Thus it follows that, economically, each of the twin brothers made a $5,000 real profit on the sale of his house. Each brother made a good salary and was in the 28% tax bracket. Happy didn't mind paying tax on the $ 5,000 quick profit he made and left his accountant's office smiling as he wrote out his check to the IRS for $1,400 ( $5,000 x 28% ) on his profit, leaving himself with a $3,600 ($5,000 - $1,400) profit after taxes. Sad knew he made the same economic profit on his house as his brother, but when he left his accountant's office there was no smile on his face, as he made out his check to the IRS in the amount of $7,000 ([$45,000 - $20,000] x 28%), turning his $5,000 economic profit into a loss of $2,000 ( $5,000 $7,000) after taxes.

This example illustrates the unfair tax treatment received by many taxpayers. In the business sector of the economy, older, established business owners who would be better off selling their assets to another company whose products are more in demand become trapped into keeping their business holdings because they cannot afford to allocate their assets to a more necessary sector of the economy due to the built-in phantom taxes.

Analysis.- The previously used flat percentage capital gain deduction partially offset this problem; however, it was not geared to economics and was a clumsy method for solving a complex problem. The old holding period for capital gain deductions in the amount of either 40 or 50% required, at differing times, either a six-month or 12-month holding period. Accordingly, taxpayers received the same rate of deduction, regardless of whether they were being subjected to "taxflation" based on a year or two of inflation or a lifetime of inflation. This inequity was being used by the rich to avoid taxes on income acquired over short periods of time through stock and securities investments, allowing them the same deduction for a one-year investment as other taxpayers received who had held property for extended periods of time.

Solution: The simple solution to this complex and inequitable situation is to allow an elective capital gains deduction based on a Consumer Price Index Deflator Deduction table that would be published with the tax tables each year. The table would have three columns consisting of: (1.) Holding Period in Years, (2.) Consumer Price Index Deflator Factor for Asset Basis, and 3.) Consumer Price Index Deflator Factor for Prior Depreciation.

The taxpayer would simply use the table to look up the number of full years (in column 1) his capital gain property was held before being sold to find the Consumer Price Index Deflator percentage factor for asset basis (in column 2). This percentage from the table would then be multiplied by the cost basis of the asset and used to determine the amount of his capital gain deduction. Alternately, the basis of the asset could be increased based on the table.

If the asset had been previously depreciated (the third column on the table) based on the inflation over one half of the asset's holding period could be used to increase prior year's depreciation and thereby be added back to the capital gain. The use of only one half of life for the depreciation adjustment factor would serve to average the inflation effect of depreciation expenses being taken over both early years and more recent years.

Finally, in the interest of tax simplicity, a small, (30% ) flat rate capital gains deduction could be elected by taxpayers selling assets with at least a five-year holding period. Loss of tax revenues would be offset by larger numbers of capital transactions and the additional ease of asset transfer would help to stimulate the economy as a whole. The combined effect would increase total tax revenues and make many taxpayers "Happy".
COPYRIGHT 1990 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Author:Galloway, Wayne C.
Publication:The National Public Accountant
Article Type:column
Date:Feb 1, 1990
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