Deborah Geier (Cleveland State) responds to this week’s Wall Street Journal editorial, Index Capital Gains (blogged here):

You suggest that the President issue an Executive Order requiring that the term "cost" basis in section 1012 of the Internal Revenue Code be interpreted to require indexing the basis of capital assets to reflect inflation. There is a fundamental problem with this: many assets have a basis not determined under Section 1012 at its "cost." Assets obtained by gift have a carryover basis under Section 1015; stock obtained in corporate reorganizations have a substituted basis under Section 358; assets obtained in such deals have a carryover basis under Section 362; property obtained in so-called like-kind exchanges have a substituted basis; and I could give many other examples. None of these other sections use the word "cost." Will the basis of these assets not be indexed for inflation under the Executive Order interpreting the meaning of the word "cost" to reflect inflation? The resulting discontinuities would be intolerable. If indexing is to be done, it has to be done legislatively so that it is done comprehensively across the entire Internal Revenue Code for all assets, however acquired.

But there is more fundamental problem. Because much (most?) taxable capital gain is realized on debt-financed assets, this means that the taxpayer is nevertheless ahead because interest is deducted at rates as high as 35% while the related capital gain is taxed at only 15%. Assume that I borrow $1,000 at 10% interest and purchase a non-depreciable capital asset for $1,000, that I sell the asset one year later for $1,100, and that I use the sales proceeds to repay the $1,000 debt principal and $100 interest. This transaction is an economic wash for me, but I am ahead taxwise, because my $100 interest deduction saves me $35 in tax, while my unindexed $100 capital gain produces only a $15 tax. This is pure tax arbitrage that encourages taxpayers to make economically pointless (or sub-marginal) investments.

If inflation were 5%, and my basis were indexed for inflation but my debt was not (a common indexing proposal), the situation would be even worse for the fisc. My sale gain would be reduced to $50 (producing a $7.50 tax), while my interest deduction would remain at $100, saving $35 in tax. If debt basis were also indexed for inflation, the interest deduction would also be reduced to $50, saving $17.50 in tax, which does not eliminate the arbitrage.

Finally, I understand that Great Britain found basis indexing to be an administrative headache.