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![handle is hein.tera/tafoutaxt0043 and id is 1 raw text is: Tax Review]
JANUARY 1979
Vol. XL, No. 1
Adjusting Tax Rules for Inflation-
Capital Gains and Capital Income
By Martin Feldstein
The tax changes that were enacted in 1978
brought some welcome relief to individual
investors and corporations. There is no doubt that
the reduction in the capital gains tax marked a
fundamental rejection of the liberal tax reform
tradition thaL has directed Congressional action
for the past decade. These tax cuts will provide a
helpful stimulus to capital formation.
But it would be wrong to be too sanguine about
the changes that have been made. I believe that
the most fundamental tax problem affecting
capital formation has not been tackled: adjusting
tax rules for inflation. With anything like the
existing rate of inflation, our current tax system
imposes an extremely heavy burden on capital
income, depressing total investment and distort-
ing decisions about its form. Modifying the tax
rules to deal with the reality of inflation is the
most urgent task of tax reform and is likely to be a
major focus of tax legislation in the coming year ....
Capital Gains
Since 1969, a number of different legislative
changes in the minimum tax, the maximum tax,
and the alternative tax have combined to raise
the effective capital gains tax rates very substan-
tially. On top of that, and I think of even greater
total importance, has been the impact of inflation
on the taxation of capital gains.
In 1977, the National Bureau of Economic
Research released a study of the impact of infla-
tion on the taxation of capital gains.' In this
1 See National Bureau of Economic Research Working Paper No. 234,
Inflation and the Excess Taxation of Capital Gains, by Martin Feld-
stein and Joel Slemrod. This study is summarized in Flow Inflation
Distorts the Taxation of Capital Gains, Harvard Business Heview.
September-October 1978.
study, Joel Slemrod and I looked first at the ex-
perience of someone who invested in a broad port-
folio of securities like the Standard and Poors five
hundred securities in 1957, held it for twenty
years and sold it in 1977. An investor who did that
would have been fortunate enough to have his in-
vestment slightly more than double during that
time. Unfortunately, the price level also more
than doubled during that time. In terms of actual
purchasing power, the investor had no gain at all
on his investment. And yet of course the tax law
would hold him accountable for a tax liability on
this nominal gain.
After seeing this experience for a hypothetical
investor, we were eager to know what has been
happening to actual investors who have realized
taxable capital gains. Fortunately, the Internal
Revenue Service has produced a very interesting
set of data: a computer tape with a sample of
This Issue In Brief
in this issue, Professor Feldstein maintains that,
while some progress was made under the Revenue
Act of: 1978 toward reducing tax obstacles to
capital formation, the most fundamental tax
problem affecting capital formation has not been
tackled, He emphasizes the need to adjust tax
policy for the effect of inflation, particularly to
achieve a more realistic measurement of capital
income subject to tax.
This piece was excerpted from remarks delivered
by Professor Feldstein at the Tax Foundation's 30th
Annual Conference on December 6, 1978. Views
expressed were his own and should not be attribu-
ted to any organization.
Copyright 1979 by Tax Foundation, Inc., 1875 Connecticut Avenue. N.W., Washington, D.C. 20009, (202) 328-4500
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