Congressmen Mike Pence and Eric Cantor want to index for inflation the cost basis of assets that are charged the capital gains tax rate. Great idea.
I concur. In a 1999 National Bureau of Economic Research volume titled The Costs and Benefits of Price Stability, Martin Feldstein contributed a paper with this conclusion:
The analysis developed [in this paper] implies that the annual gain that would result from reducing inflation from 2 percent to zero would be equal to between about 0.76 percent of GDP and 1.04 percent of GDP.
How that translates into a long-run benefit depends critically on assumptions about how to discount future gains to the present, among other things. With Feldstein's preferred assumptions, the gain is as high as 40 percent. That can be debated, but suffice it to say that even with quibbles about the exact assumptions to apply -- and other details of the analysis -- the net gains would be pretty darn big if Professor Feldstein's analysis is anywhere close to correct.
In the paper, Feldstein conceded:
... adverse effects of the tax-inflation interaction could in principle be eliminated by indexing the tax system... As a practical matter, however, such tax reforms are extremely unlikely.
Fair enough, but the real reason to prefer indexation to "reducing inflation from 2 percent to zero" may be that reducing the rate of inflation to zero might not be such a good idea. During his first tour of duty on the Board of Governors of the Federal Reserve System, Ben Bernanke made these remarks:
I need to introduce the idea of the optimal long-run inflation rate, or OLIR for short. (Suggestions for a catchier name are welcome.) The OLIR is the long-run (or steady-state) inflation rate that achieves the best average economic performance over time with respect to both the inflation and output objectives.
Note that the OLIR is the relevant concept for dual-mandate central banks, like the Federal Reserve. Thus it is not necessarily equivalent to literal price stability, or zero inflation adjusted for the usual measurement error bias. Rather, under a dual mandate, a strong case can be made that, below a certain inflation rate, the benefits of reduced microeconomic distortions gained from price stability are outweighed by the costs of too frequent encounters of the funds rate with the zero-lower-bound on nominal interest rates...
... studies of the costs of very low inflation (such as the supposed effects of downward nominal wage rigidity on the allocation of labor) have found that these costs are also largely eliminated at inflation rates of about 2 percent...
At the very least, the gains of reducing the distortion on capital returns would be diminished by pushing the rate of inflation lower than would otherwise be "optimal." Indexing is the better approach.
Of course many of you have have already anticipated these remarks, from current Bank of Israel Governor Stanley Fischer (emphasis in the original):
... we should note that this paper is entirely an argument for reducing capital taxation. Inflation is essentially incidental to the argument -- reducing inflation is simply a means of reducing capital income taxation.
That's a fine point, and the Feldstein article does duly note that the appropriate way to analyze a tax rate reduction is to insist on revenue neutrality (at least in a present value sense). You may think that capital income taxes are just fine where they are. I won't object (at least not here). But even so, is it really a good idea to use monetary policy to engineer tax policy? Isn't the right approach to insulate statutory tax rates from the potential influence of inflation, and leave fiscal policy decisions to Congress?
I think so.