Pro-growth enthusiasts are heartened by a tax proposal that’s been dusted off and put back on the legislative front burner.

A bill to index capital gains taxes for inflation was introduced in the U.S. House last week. While Congress has very few legislative days left before it recesses for the campaign season, indexation optimists are hopeful they can find a legislative vehicle to move the provision — perhaps during a lame-duck session that would follow the November elections.

Taming Inflation’s Sting

Indexing capital gains for inflation advanced several times in Congress during the 1990s, but the measure never quite made its way into law. Two cuts in capital gains taxes have occurred during the past decade – one during President Clinton's term in 1997, and another as part of President Bush’s tax package in 2003. Neither included indexation.

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Indexing is now back on the agenda with the introduction of H.R. 6057, a bill that would index for inflation the cost basis used in calculating the capital gains tax .

"The American people should not be taxed on inflation," said Rep. Mike Pence, R-Ind., upon introducing the bill with Eric Cantor, R-Va.

"Congress should give family farmers and small business owners a break by eliminating the tax on inflation when calculating capital gains," Pence added.

Currently, many individuals who pay the capital gains tax pay a tax on inflation. The purpose of indexing is to insure that only real gains are taxed.

Raymond J. Keating, chief economist for the Small Business & Entrepreneurship Council (note: the writer’s organization) says that such indexing is important to small businesses and our economy as real capital gains tax rates directly affect the bottom line on entrepreneurship.

“If we want solid economic growth, then we need to encourage such risk taking. A higher real capital gains tax rate does just the opposite,” says Keating.

Beginning in 2007, H.R. 6057 would provide that a taxpayer holding an asset for more than 3 years will have the gain or loss determined by a cost basis adjusted for inflation using the “Gross Domestic Product Deflator.”

A study by the American Shareholders Alliance (ASA) found that 33 percent of the increase in shareholder wealth was attributable just to inflation during the years 1979-1994. This percentage represents an accumulated $1.5 trillion on non-real gains for investors. Without adjusting capital gains for inflation, these purely inflationary gains are taxed at the same rate as real gains.

Keating crunched some numbers to illustrate how inflation increases the real tax rate on capital gains. A $1,000 investment in the S&P 500 made in 1997, for example, would have grown to $1,382 in 2005. On that return, the capital gains tax paid at the nominal 15 percent tax rate would be $57.30. But after adjusting for inflation, the real capital gains tax rate jumps to 33.9 percent.

In some cases, individuals are currently taxed on real economic losses — that is, if the pace of a gain is less than inflation. Not indexing for inflation has other consequences that hurt the nation’s economy and competitiveness in the long term.

“Under current policy, shareholders are being taxed on inflation adjusted losses as gains which obviously discourage long-term investing,” says ASA Executive Director Daniel Clifton. “At the same time, current policy inhibits long-term economic growth by making long-term capital investments less certain and far more risky.”

Would indexing be too complicated for taxpayers to figure out? That is what some opponents of indexing claim. In reality, indexation would require merely one additional step of multiplication for taxpayers, according to Keating.

Likely, the most complicated part of indexing could be getting it through both chambers of Congress. But there’s hope some type of movement will occur.

“When the push began to index capital gains in June, pundits said there was no chance of this passing. But momentum is building and this initiative now has a 50 percent chance of passing before the end of the year,” said Clifton.

Alternatively, if Congress does not act, a legal debate is swirling over whether the president has the legal authority to achieve this goal by Executive Order. A 1992 Chamber of Commerce study concluded the president does have the legal authority to reinterpret the cost basis for calculating capital gains by excluding inflation.

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Karen Kerrigan is president & CEO of the Small Business & Entrepreneurship Council, a research and advocacy group based in Washington, D.C. that works to protect small business and promote entrepreneurship. She is also founder of Women Entrepreneurs, Inc., an association helping women business owners succeed through education, networking and advocacy. Kerrigan can be reached at kkerrigan@sbecouncil.org.