CAPITAL GAINS AND GAMES

By Daniel Kadlec

Simple is often best. But as people who do their own form 1040s can attest, that isn't exactly a guiding principle of the U.S. tax code. So it's a bad joke that the current debate over tax relief for investors centers on a cut in the capital-gains tax, the 28% levy that you pay on stocks, bonds and other assets held more than a year and sold at a profit. The bad part is that while it would be relatively easy to install--Poof! Your tax rate is lower--what the Federal Government really needs to do is figure out a more complex but also more beneficial fix, one that adjusts for the ravages of inflation. Don't get me wrong. A cut in the capital-gains tax rate is a good proposal. But simple is not best in this case. Indexing for inflation is a better plan, even if it's too logical for policymakers.

The buzz for tax relief has rarely been louder, and is part of a bipartisan deal to balance the budget by 2002. More important, there is mounting grass-roots support for cutting taxes on investment gains. Thanks to a roaring bull market, and the fact that anyone with two nickels to spare is in stocks, Wall Street windfalls are no longer reserved for the rich. A survey by the NASDAQ stock exchange shows that the proportion of adults owning equities has doubled, to 43%, since 1990.

The most prominent proposal for how to cut capital-gains taxes would exclude 50% of gains and tax the rest as ordinary income, effectively cutting the top rate to 19.8%. The change would apply to assets sold after May 7, 1997. Almost no one is talking up indexing stock profits for inflation as an alternative, because it's seen as a record-keeping nightmare. It requires a different adjustment for every holding period. The goal of indexing is to eliminate taxation on capital gains that result from inflation rather than from a real increase in value. Say you buy $10,000 worth of a stock, and after a year its market value is $10,300, up 3%. If the inflation rate that year was 3%, you effectively had no gain. Yet if you sell, you owe tax on the $300 nominal profit. Indexing for inflation would ensure that you pay on gains only beyond the $300. Perfectly logical. A Congressional Budget Office study found that in 1989 the sale of U.S. assets generated net capital gains of $47.3 billion. But adjusted for inflation, those transactions actually produced losses of $17.4 billion. "People were paying taxes on sales where they lost money," says Mark Bloomfield at the American Council for Capital Formation.

With inflation at its current low rate of 3%, the two alternatives are a wash for those in the highest tax bracket: a stock bought at $100 and rising 10% a year for a decade generates an after-tax profit of about $125 in either tax scheme. Now, all those who think inflation will remain at 3% forever, raise your hands. Hmmm, just what I thought. The risk is that inflation will pick up, and at just 4% annual inflation the numbers start to make indexing a better deal for individuals. That, unfortunately, translates into a cost for the government and may be seen as a budget buster.

There are, of course, good reasons to like a rate cut. It would apply immediately to long-held assets with huge unrealized gains. That has obvious appeal to the aging Sunbelt crowd and could unlock tremendous sums to be spent and further the economy--which in turn would enrich federal coffers. It also would be a boon for anyone holding stocks that rose more than, say, 10% a year. But those lucky people can afford the 28% tax. Indexing for inflation protection encourages the young to commit to the stock market long term. There, history has proved, they will earn the best returns, which helps solve the looming crisis of retirement security when Social Security officially goes bust in 20 years.

Daniel Kadlec is TIME's Wall Street columnist. Reach him at kadlec@time.com