Thursday, May 11, 2006

Some Thoughts on a Tax Hypo

So here's the setup:

TP buys a house in 1977 for $40k. At some point between 1977 and 2006, TP buys a second house, ceases to live in the first house, and begins renting it to tenants. In 2006 TP sells house 1 for $225k, realizing a $185k ($225k sale price minus $40k cost basis) long term capital gain on which TP pays tax of $27,750 (figured at the current LTCG rate of 15%).

That's the setup. Here's the problem. TP paid $40k for the house in 1977 dollars, but only got a return of $40k in 2006 dollars for his investment. $1 in 1977 is worth $3.30 in 2006 (calculated using the inflation calculator at the Bureau of Labor Statistics). That means that $92k of the gain realized on the sale of the house is due to inflation. In other words, it's not real economic gain. TP's real economic gain on the sale is $93k ($185k amount realized minus $92k inflationary gain) which would have yielded a tax liability of $13,950. It seems as though TP is being taxed $13,800 too much.

The problem seems to stem from the fact that TP's cost basis is not indexed to inflation. If it were, TP's basis in house 1 would have been $132k in 2006. So the proper result would seem to be to index the basis of capital assets (or any asset held for more than a couple of years) to inflation. So why don't we?

It would be hard, for one. Since the Internal Revenue Code of 1954 was enacted, Congress has elected to provide a reduced rate of taxation for capital gains instead of the inflation index. In the Contract with America Tax Reduction Act of 1995 (or maybe 1993 or maybe 1997, I'm not entirely sure) inflation indexing was suggested. Some (mainly Democrats) proposed the indexing in lieu of the favorable rates. With their backs against the wall, the Republicans picked the favorable rates with no indexing.

This was not the first time the same choice had been made. For the past few decades, inflationary indexing has surfaced again and again. After all, it is the conceptually correct approach for an economically neutral income tax that is targeted on actual economic enrichment. However, for reasons I might talk about in a later post, Congress has consistently chosen a favorable rate over indexing for long term capital gains as a sort of rough compensation for inflation.

So the point of this very abreviated tour through Congressional decision-making is that TP is comparing apples and oranges when he looks at the difference between the gain realized under current tax law and the gain he "should have" realized under a non-existent inflation-indexing law coupled with favorable rates. What TP should look at are these numbers:

$27,750 tax liability under the current non-indexed but favorabled-taxed regime on the one hand,

versus

$32,550 tax liability under an inflation-indexed regime taxed at the TP's highest marginal rate.*

So it seems like under the conceptually flawed lazy approach of the current code, TP is still better off than he would be under a more conceptually correct approach that recognized only real economic gain and taxed it properly.

*I assumed that TP was in the highest bracket mainly because he was able to buy a new house without selling his old one. In the second-highest marginal rate, the results would be similar. Under the third-lowest marginal rate, 28%, TP would be better off with the indexing.

6 Comments:

Blogger Nell said...

I'm sorry... I only made it 5 words in. I can't do it. No more tax.

10:26 AM  
Blogger Xeno said...

Lets go to the LDWCS tax system. This system has only one rule... lets do what Chris says. For instance women are taxed inversely based on their Chris aproved hottness rating.

6:44 PM  
Blogger warm fuzzy said...

FishFrog, you are Tax-riffic!

9:42 AM  
Blogger Expatriate Owl said...

The problem is that there is an income tax in the first place!

The thing about income taxation is that no two households process economic inputs quite the same. Similarly, cows process grass differently than humans and other animals, and just because a cow can live on the grass in my back yard does not mean that my family can (though, if there be enough grass, my family can live on the cow's milk (income) or the cow's flesh (capital).

Thus, two government civil service employees, hired the same day and drawing the same salary and living in the same neighborhood, are unlikely to drive identical model automobiles, go to the same vacation spots, purchase identical groceries, or drink the same brand of whiskey (which is still taxed, by the way).

Each household processes its dollars differently. Yet, our tax system effectively works under the premise that a dollar is a dollar is a dollar.

-- Expatriate Owl

2:13 PM  
Blogger Fishfrog said...

While it's true that individuals structure their consumption in unique ways, I fail to see how that has any effect on income taxation. Are you suggesting that if I choose to buy an Audi instead of a Toyota, 92% lean ground beef instead of 90%, or Jack Daniel's Single Barrel instead of Jim Beam, that I should pay less in taxes?

Two people whole make $50k a year in straight wages, have a wife and two kids each, and are otherwise similarly situated are in economically identical positions the moment they receive their pay checks. The federal government will apply the same rate of taxation to each regardless of how they choose to spend the money. (This isn't really true; the gov't subsidizes many behaviors through the allowance of personal deductions for home mortgage interest payments, certain employer-provided fringe benefits, health care savings accounts, etc. etc. But for the purposes of addressing your point, Expat Owl, it's true enough)

Our tax system does treat a dollar as a dollar. One reason for this is that the dollar is a proxy for the psychological benefit of consumption, which, some would argue (see Andrews 1974 Harvard Law Review article) is what we should be taxing. In other words, a dollar is a fairly reliable proxy for imputed income. If I pay $1 for a burger, we know that that burger brought me (or at the time of purchase I believed it would bring me) at least $1 of psychic income. It could be that I would have paid more for the burger, and one could argue that I should be taxed on exactly the benefit I actually got from the burger. But from a practical valuation standpoint, that would be unworkable.

Let me know if I understand what you're saying, Expat, cause I love talking tax.

2:29 PM  
Blogger Expatriate Owl said...

Fishfrog, I believe that we do understand one another, and even agree on many points, even though we effectively are speaking in two different languages.

If indeed we are to have an income tax, then we must tax equal incomes equally, notwithstanding individual consumption preferences (and, as you note, notwithstanding the thorny issue of just what qualifies as a deduction from income).

And no, I am not suggesting that you should pay less taxes just because you purchase a Jack Daniel's Single Barrel instead of a Jim Beam (actually, I recently purchased both -- I don't wish to waste single barrel bourbons or single malt scotches to those who cannot appreciate quality beverages; Jim Beam and Dewars are good enough for them!).

If indeed we are to have an income tax, then all of your explicit and assertions regarding the income tax are valid.

My gripe is not so much over how we administer or should administer the income tax; it is more about the fact that we have an income tax at all. I favor an excise tax system instead of an income tax system (not that such a system would be problem-free). Ditto with Estate taxes. My reasons are set forth in my own blog, in entries posted 11 October 2005, 24 January 2006 and 3 February 2006.

(As is obvious from the various entries on my own blog, I, too, love to talk taxes.).

11:28 PM  

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