Treasury Secretary Nick Brady yesterday threw cold water on the idea of indexing capital gains by decree: "If we could do it, we would," but "We have had no competent legal advice that you could do it." This was the predictable position of the Cabinet official who has done more to bring the American economy to its knees than anyone. Nevertheless, we think the chances of this happening are increasing, not decreasing, as the idea circulates. The debate is taking shape along the following lines:
As The Wall Street Journal editorializes this morning, there is great eagerness in Congress to pass a tax bill that the President can sign into law prior to November 3, but the Democrats will not let that happen if there is even a whiff of capgains in the bill. As usual, Brady is insisting, along with White House Chief of Staff Sam Skinner, that they should not fight the Democrats on the "fairness issue." HUD Secretary Jack Kemp has irritated Brady, Skinner and others by urging the President to veto any bill that shows up on his desk without capgains. Vice President Quayle is advancing the interesting idea that the President should advise the Democratic leaders that unless they at least include capgains indexing in the legislation, he will do so by executive order. The Democratic Party already has prospective indexation in its platform and Governor Clinton is committed to that idea. So what's the problem?
The liberal Democratic theologians, led by Yale's James Tobin, insist that indexing retrospectively would have no positive effects on the economy as those investment decisions have already been made. This model only loses revenue. In the supply model, hundreds of billions of dollars of capital are frozen by the threat of tax confiscation. This capital would be liquified instantly, flowing to higher and better uses. More importantly, if it is wrong to tax inflation as capital, it's just as wrong to tax it today as it is to tax it tomorrow. If the President insists the tax bill that comes to his desk contain an indexing provision, it should be one that simply sets out the definition of capital gains, deflating all nominal gains by the GNP deflator no matter how far back in time an asset was purchased. If a family farm purchased in 1942 was sold yesterday, and now faces a tax liability of $50,000. The IRS would have to take 50 years of inflation out of the sale price, which would likely eliminate entirely the tax liabilities of most such sales. It would be right to do so, economically, politically and morally.
The Democratic leadership would scream, insisting the President does not have the authority to index, even citing Nick Brady's statements. If they proceed without including an indexing provision in the legislation they send to his desk for signature, he could satisfy both wings of the GOP by signing the bill and, at the same time, making good on his promise to index by executive order. The pro capgains forces I've spoken to in the Congress and in the White House also like the idea of having the President sign an executive order dated November 4, which permits him to say that if the American people do not like the idea and do not re-elect him, the order will be null and void, and the issue will be left to President Clinton. This approach, I think, will not only rescue the President's re-election chances, but will also provide a cutting-edge issue, a battering ram, for growth-oriented House and Senate candidates.
President Bush is not losing to Clinton in the California poll by 34 points because Californians have taken a shine to the Arkansas Governor. He's a nice young man, but we don't know much about him. The electorate would still prefer the President to snap out of his torpor and show some signs of life. Imagine the electorate as a young woman, distressed because her boyfriend pays no attention to her anymore, spending all his time playing horseshoes. She flirts openly with another fellow, a heavy breather, hoping to arouse some sense of jealousy and proprietorship in her preferred swain. But if he remains emotionally inert, relying on good luck horseshoes to win, she might as well make the switch. Capgains indexing, which would finally excite the economy into action, is all President Bush needs to regain the affections of an American people that was dizzy about him just 12 months ago.
Is Brady right, however? Does the President lack the authority to index the basis of capital assets for inflation by regulation, without the need for congressional action? Lawrence Zelenak, a tax law professor at the University of North Carolina, has done the most recent scholarly analysis of the question, as a result of the article Paul Craig Roberts wrote for the Washington Times January 22, "Instant Way to Cut Capital Gains Tax." In Tax Notes of May 11, Professor Zelenak, who doesn't like the idea simply because it has never been done before, argues that the President doesn't have the authority, but that if he did it without authority, there's nothing Congress could do to thwart him -- short of explicitly writing into law the requirement that the Government tax inflated gains. There is nobody in Congress who would contemplate trying to get such ridiculous legislation passed. If they did, they would be tarred and feathered in their districts.
Would the courts strike down the President's order? Professor Zelenak thinks not: "Despite the invalidity of regulatory indexing, indexing would probably be immune from judicial challenge. A taxpayer would be disadvantaged by indexing only in the unlikely event that deflation caused a downward basis adjustment, thus increasing the taxpayer's capital gain (or decreasing capital loss). Absent deflation, indexing could work only to the advantage of particular taxpayers, and without a disadvantaged taxpayer there would almost certainly be no one with standing to challenge the new regulation." Isn't that too bad!
Brady's reliance on legal sophistry to prevent something good from actually happening to the U.S. economy is concrete evidence of the inertia in the Administration. If he were at Treasury instead of at HUD, Kemp would issue the order in a minute, without bothering to ask counsel. Why would he need a lawyer to tell him he cannot define capital without including inflation? If Nick Brady had outside his office a picture of a chicken, with a sign on it marked "Duck," would he have to ask the Attorney General if he could make the correction?
This issue would not exist if the U.S. Government did not decide in 1971 to inflate the dollar, thereby cheating its creditors out of the value of their capital. If it was reprehensible for the Government to do that, as it surely was, think now how outrageous it is for the Government to exact a tax on the inflation it created by defining inflation as capital!
One of the reasons the Administration did not plow ahead with indexing earlier this year, "despite the invalidity of regulatory indexing," was the sense around the President that it wasn't necessary. The economy was going to get better on its own. The President was going to annihilate a Democratic ticket headed by "a philandering, pot-smoking draft dodger." Why stir up a fuss with the Democrats? Why make Senate Majority Leader George Mitchell have a canary? Might we not need him to pass a big foreign aid bill -- to bail out the banks with taxpayer money?
It looks a lot different now with the economy still stinko. The President is so far down in the ratings there is widespread discussion among Republicans that he should stand aside to prevent annihilation of GOP candidates at every level. George Will's Washington Post column was the first, but there are many others being contemplated. This, I think, is the only shot he has left, or in another two weeks, when the GOP convention opens in Houston, he might see petitions from GOP leaders pleading for him to quit, while there is still time for the convention to pass the baton. We're going to watch this very carefully as a breakout would cause grief to those of you who are short the market. I'll be in Washington next week as the plot thickens.