Remove inflation distortions from the tax base


One of those “deja vu again” periods continues with a sudden surge in inflation. According to the historical inflation rate table from the US Inflation Calculator, we were 4.2% in April 2021, over 5% from May to September, 6.2% in October and 6.8% in November. The last time we had such a bad April to October was in 1982, but of course we were used to it by then. The Federal Reserve’s story calls it The Great Inflation and dates it from 1965 to 1982. What cost a dollar in 1965 cost $ 3.06 in 1982. In contrast, what cost a dollar in 2003 cost 1.41 $ in 2020.

One of the worrisome aspects of inflation is that it skews the measurement of income. Someone who bought stocks in 1965 for $ 1,000 and sold them in 1982 for $ 3,000 did not break even in constant dollars, but would be taxed on a gain of $ 2,000. Believe it or not, this issue has been carefully addressed. And you can read all about it in Tax Reform for Fairness, Simplicity and Economic Growth – The Treasury Report to the President – Volume 1 and Volume 2.

How it all started – and ended

You can get an account of the birth of the 1984 report and what was made of it in one gripping story – Showdown at Gucci Gulf – Lawmakers, lobbyists and the unlikely triumph of tax reform by Jeffrey H. Birnbaum and Alan S. Murray. Here is their explanation of the inflation proposal in the report:

But Treasury tax experts wanted to go much further. They wanted to adjust everything for inflation: capital gains, depreciation, even interest payments and interest deductions. According to their plan, a lender would be taxed on interest income only to the extent that the interest rate exceeded the rate of inflation. Likewise, a borrower could only deduct interest payments to the extent that the interest rate exceeds the rate of inflation. Such a comprehensive indexation was a daring and ambitious effort, but also complex and confusing. It was an essential part of the ideal tax system, but unlikely to win the support of pragmatic politicians.

It’s complicated – Maybe too complicated

The cash proposal aimed to measure true economic income and tax at rates independent of how income was earned. It was a bold goal. When it came to accounting for the effect of inflation, there were different types of assets to consider – depreciable assets, other non-interest-bearing capital assets, inventories, and interest-bearing assets.

Depreciable assets

The proposal would establish the Actual Cost Recovery System (RCRS). RCRS is not an accelerated system like ACRS or MACRS. Rather than waiving a percentage of the original cost, the cost recovery deduction is a fixed percentage of the remaining base ranging from 3% to 32%. In the absence of inflation, that would give you a tapering deduction that would never fully cancel out the cost of the asset. Put simply, you would write off the balance when you were down to just 15% of the original inflation-adjusted base. Each year, the adjusted asset base would be increased by inflation. The long-lived asset base and the subsequent capital cost allowance would actually increase in times of high inflation.

Fixed assets

Other types of non-interest bearing assets would benefit from an annual adjustment for inflation. There were somewhat complicated rules about what happens in the year of acquisition and the year of disposition. Quite simply, each year there would be a base adjustment to the asset. The presumption seemed to be that it would always be an upward adjustment. There was a complex set of transition rules, but once it was operational, all fixed assets covered by that part of the system would have a basis equivalent to what was paid for them in dollars in the year they were acquired. or on January 1, 1965 if they were really old.

Inventory

The proposal would have added the indexed FIFO (First In First Out) as an additional eligible method in addition to the FIFO or the unindexed LIFO (Last In First Out). Studying this at the time, I wasn’t too excited as the most common method for JBC clients seemed to be WIFL (Whatever I Feel Like).

Certain financial assets

With regard to the assets that bore interest, they took a different approach. Rather than indexing the principal of the bond, a portion of the interest was excluded from income or deduction based on the rate of inflation. If inflation was 1%, then 14% of the interest deduction would be disallowed and a corresponding amount of interest income would be excluded. At 12% inflation, the exclusion / refusal percentage would be 67%. The fractional exclusion rate was calculated using an assumed real rate of return of 6%. A lower real rate assumption would result in a higher exclusion. Most interestingly, if you had a different functional currency, there would be a different exclusion.

Implementation

I just loved this proposal because it created the need for some really cool working papers. It was the dawn of laptops. Although the Kaypros we acquired around this time, weighing over 25 pounds, are more transportable than portable. Using Perfect Calc was so powerful that we charged them as staff at $ 50 an hour. It would have been so cool. The internet was around then, but it wouldn’t infiltrate offices like ours for over a decade.

Death on arrival

The Treasury report was one of the first tangible steps on the way to the Tax Reform Act of 1986. The idea was to give us an income tax that would tax all income, regardless of its source, on the same. much lower rate table. One of the justifications for the prime capital gains rate was capital gains inflation. But the special tariff is an imprecise way to solve this problem and it leads to a lot of complexity and slack in the system. The indexing system proposed in the report is conceptually much cleaner.

According to Strong test it was Senator Bill Bradley who got the ball rolling. As a high income basketball player for the New York Knicks, the tax shelter culture really messed him up. The concept gathered bipartisan appeal. For this to work, it had to be revenue neutral and not change the distribution of income tax among income groups except to exempt those at the bottom of the ladder.

A team of hard-line tax thinkers under the leadership of Treasury Secretary Regan drafted the proposal without any political input. They achieved the lowest rates of up to 35% instead of 50% by slaughtering or mutilating a herd of sacred cows – exclusion for unemployment and disability, exclusion for prizes and awards, deduction for national and local taxes, charitable deductions , deductions for travel, meals and entertainment expenses, credit for political contribution and withholding for the presidential campaign, deduction for adoption expenses, energy tax credits, percentage depletion, intangible drilling costs, mineral exploration lasts, tax exemption for credit unions, exemption from internal accumulation of life insurance and annuity value, building rehabilitation credits.

Some of the proposals that would have resulted in a cleaner tax system have given up on revenue. There was a proposal for C corporations to deduct dividends to the extent that they came from income that had been subject to corporation tax. Some business executives weren’t too excited about the “hiatus” as it could put pressure on them to pay more dividends. The indexing of various fixed assets and inventory was also a loss of revenue. And there really was no kind of riding. So that was one of the first things that was rejected when serious negotiations started.

Can we ever have real tax reform?

The Tax Reform Act of 1986 was a great success and it was truly a step towards a more rational tax system. But what happened? It turns out that using the tax code as an instrument of social and economic policy is just too tempting. It sounds too much like a free lunch. And any special arrangement will have a fierce constituency. Whenever the notion of tax reform is raised, it is supported in general and attacked in particular. In 2013, I wrote the generic response that follows calls for tax reform:

Comprehensive tax reform and simplification is a fantastic idea. We here at the ABC Coalition for DEF love the idea that you are working on it and we totally support you. Of course, we’re sure you know DEF is essential to the American way of life and to the health, safety, and well-being of the world. We just want to remind you that the GHI deduction and JKL credit play a vital role in supporting DEF. So when doing your simplification, don’t even think about playing around with the GHI deduction and the JKL credit. In fact, you should probably beef them up a bit and deal with the MNO exemption that we requested. Other than that, take away those special tax breaks and give us a simpler code.

Won’t you come back Bill Bradley?

The 1986 Congress was like Isildur having the power to destroy the One Ring and refusing to do so. Using the Internal Revenue Code to do anything other than raise necessary revenue is inherently corrupt, I was happy to find that former Senator Bradley is still with us. I contacted his office, but got no response. Maybe we need him to come back. He hasn’t recently performed a one-man show on his life. Maybe he can add another chapter. We can see in this room that he is still thinking about what is required.

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