April 10 (Bloomberg) -- Investors can deduct $3,000 in capital losses against ordinary income, a benefit that cushions the sting of a failed investment. It’s a tax break frozen in time, stuck at the same nominal dollar amount since 1977.
The cap isn’t indexed for inflation. Its benefit erodes every year. The break would be worth more than $10,000 if it was pegged to inflation like other parts of the U.S. tax code.
This provision -- along with the similarly frozen $1,000 child tax credit and $25,000 income level before Social Security benefits are taxed -- are absent from the political debate. Lawmakers have focused instead on which measure of inflation to use for the parts of the tax system that are already tied to prices. President Barack Obama will include in his budget proposal today a plan to switch to a lower inflation gauge known as the chained Consumer Price Index.
That means these other benefits cease to do what Congress intended in the first place as they become less valuable, especially if inflation picks up.
“In some ways it’s like an unexploded bomb in the income tax,” said Leonard Burman, a tax professor at Syracuse University in New York. “Because if we do have a bout of inflation in the future, all these distortions would get much bigger.”
The president has said his budget for the 2014 fiscal year will raise taxes for upper-income households. In addition to chained CPI, it proposes long-term cutbacks in Medicare, while adding spending for infrastructure projects and government research programs.
Switching to chained CPI would subject more income to taxation and increase benefits slower than under current formulas. The change would cut $216 billion in spending and raise $124 billion in revenue over the next decade, according to the Congressional Budget Office.
Obama’s proposed change would affect dozens of provisions in the tax code, such as the tax brackets, the standard deduction and the personal exemption, which are adjusted automatically each year. It also would mean slower benefit growth in Social Security and food stamps.
Chained CPI is calculated differently from the measures of inflation that are currently used to adjust benefits and tax code parameters. It considers the effect of consumers switching to lower-priced substitutes -- chicken instead of beef --instead of paying more for the same product.
CBO estimates that the annual update for chained CPI would be 0.25 percentage points lower than what’s called for under current law. The consumer price index increased 0.7 percent in February and 2 percent over the past year, according to the Labor Department.
While chained CPI is the subject of lobbying campaigns and legislative maneuvering, the unindexed tax parameters scattered throughout the code are rarely discussed in Congress.
Obama’s budget proposal wouldn’t alter provisions such as the $500,000 exclusion from capital gains taxes for which married couples are eligible when they sell a home. That has been fixed in the tax code since 1997.
It also wouldn’t change the $1 million cap for the size of a mortgage on which interest can be deducted. That hasn’t changed since 1986.
Capital gains are also counted in nominal terms, meaning that taxpayers often pay taxes on gains due to inflation.
For decades, the core tax parameters -- the brackets, the standard deduction and personal exemption -- weren’t indexed. That led to the phenomenon known as bracket creep, in which the income tax system led automatically to higher taxes collected by the Internal Revenue Service, an arm of the U.S. Treasury.
Congress would raise the thresholds every few years, Burman said, providing a tax cut while leaving taxes higher than they would have been with indexed parameters.
“Politically, it’s a more popular way to raise revenues than explicitly raising taxes,” he said. “Because most people don’t think about things in real terms.”
The inflation of the late 1970s exacerbated bracket creep, and Congress pegged the major parameters to inflation as part of President Ronald Reagan’s 1981 tax cuts.
In January, Congress linked the income thresholds in the alternative minimum tax to inflation, replacing a 1986 policy that had led Congress to enact repeated temporary patches to prevent the parallel levy from expanding.
What’s left without an inflation peg are dollar amounts scattered across the U.S. tax code, sometimes intentional and sometimes from neglect or congressional paralysis.
“There’s no rhyme or reason to it,” said Alan Viard, a resident scholar at the American Enterprise Institute in Washington, a group that favors market-based approaches to policy. “Anyone who’s going to try to figure out some rationale’s going to be disappointed.”
The rules for taxing Social Security benefits, for example, were part of the 1983 bipartisan agreement to extend the program’s solvency. Not indexing the thresholds was a way of phasing in a tax increase over time.
In 2010, Obama’s health care law created a 3.8 percent tax on investment earnings of single taxpayers with incomes exceeding $200,000 and married couples exceeding $250,000 and a 0.9 percent tax on wages at the same income levels.
To help meet the law’s budget targets, those income thresholds weren’t indexed, and the tax will expand to affect more households. By 2022, 4.6 percent of households will pay at least one of those two taxes, up from 2.4 percent this year, according to the Tax Policy Center.
There’s a similar effect built into the child tax credit. The $1,000 limit isn’t indexed and neither is the $110,000 income threshold where the credit starts shrinking for married couples.
Only a handful of unindexed provisions help taxpayers. For example, people taking casualty and theft losses must subtract $100 from their loss before taking the deduction.
“It would be hard to overstate the triviality of that,” Viard said.
The Senate explicitly rejected a higher limit for the capital loss deduction in 2009, during debate on the stimulus law. Then-Senator Jim Bunning, a Kentucky Republican, maintained that a $15,000 limit would encourage risk taking.
His plan failed on a 41-55 vote, and the issue has received almost no attention since.
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