NEW YORK -- On the tax-cut tote board, the cut with the highest odds of success is the one proposed for investment profits, otherwise known as "capital gains." The average tax on certain capital gains would descend almost to zero, under the GOP proposal. Holders of profits in stocks and real estate would cheer.
As a practical matter, however, this bill is a neutron bomb. Its appalling complications would add volumes to the tax regulations and hours to your paperwork. The cuts -- far too deep to pay for themselves in revenue growth -- are projected to add $54 billion to $61 billion to the federal deficit over five years. And the rules invite tax-shelter abuse. You'd have another chance to blow your life savings on fraudulent shelters, in case you missed it the last time around.
The mischief lies in the proposal to index capital gains. The idea is to tax only "real" profits -- that is, only profits that exceed each quarter's inflation rate.
As an example, say you made a $1,000 investment which grew to $1,600, and during that time inflation rose by 10 percent. Today, you'd be taxed on the full $600 profit. Under indexing, your original cost would be scaled up to $1,100 (a 10 percent inflation adjustment) -- leaving you a reported gain of only $500.
The GOP also wants to shelter half of all your long-term gains (namely, gains on investments held for more than a year). So in this example, you'd be taxed on $250. In the 31 percent bracket, your tax rate would be 13 percent.
That's simple to write, but not nearly as simple to put into practice, says Michael Schler, tax partner at the New York law firm of Cravath, Swaine & Moore. Here are some mild examples of the tax problems indexing would create.
* If you own a mutual fund and reinvest dividends, every reinvestment would have to be figured at a different inflation rate. Think of the records you've have to keep. The mutual fund would be allowed to index, too, so theTreasury Department would have to write detailed rules to coordinate the fund's inflation adjustments with those of its various investors.
* Bonds are not indexed. If you had a stock-and-bond fund, your inflation adjustment would be keyed to the percentage of stocks in the fund's portfolio. Under the bill, this particular adjustment would have to be made for every month you owned the fund -- a huge paperwork burden when you sell.
LTC * If you own your home, every home improvement is treated as a reinvestment. So each would have a separate inflation adjustment. For long building projects, time would become an issue. If you added a deck and paid for it over two calendar quarters, you'd have to allocate the cost and index it at two different inflation rates.
The new tax-shelter angles will gladden any hungry heart. I'll mention just two that the bill allows:
* If you earn a gain that's less than the inflation rate, it becomes a tax-deductible loss.
* Assets are indexed but not debts. This would encourage financial shell games that yield small gains at little or no risk. The profit would be partly or fully sheltered by indexing; the loan interest would be tax deductible.
There are other problems with this proposal.
For one, it's glaringly inefficient. The tax cut greatly favors stocks over bonds, real estate over bank accounts and certain types of business investment. Under capitalism, the free market is supposed to determine the best places to invest. When big tax incentives are offered, the government decides instead.
For another, this tax cut indulges the rich. Of all net long-term capitalgains reported to the IRS, including gains on homes, 51 percent go to taxpayers with incomes topping $200,000, although this group accounts for less than 1 percent of all tax returns. Those with incomes under $50,000 account for 75 percent of all returns -- but they report only 21 percent of the capital gains. Capital gains cuts do not affect your retirement plans, withdrawals from which are taxed as ordinary income.
Finally, this giant tax cut would have to be funded with bloody cuts in government spending. Congress would do better to leave capital gains taxes alone and apply spending cuts to the deficit instead.
Jane Bryant Quinn is a syndicated columnist. Write to her at: Newsweek, 444 Madison Ave., 18th Floor, New York, N.Y., 10022.