Partial Basis Indexation: Tax Arbitrage and Related Issues

Abstract

The capital gains preference has been justified as a second-best response to flaws in income taxation. This Article posits, however, that partial basis indexation (of assets but not debt) is a better second-best alternative than the preference.

The preference has been supported as a desirable offset to the excess inclusion of inflationary gains in the tax base. Separately, the lower rate reduces the incentive under the realization requirement to defer the tax on appreciated assets by retaining such assets (the "lock-in" problem). The lock-in response is the stronger of the two justifications since the preference is an extremely poor response to the inflation problem; i.e., the uniform lower rate fails to take into account the percentage of the gain attributable to inflation. Partial basis indexation therefore is clearly superior to the preference at first blush. Basis indexation, which removes inflationary gains from the tax base, more directly responds to the inflation issue. In addition, basis indexation simultaneously addresses the lock-in problem by reducing the amount of taxable gain.

Partial basis indexation has failed to gain acceptance over the preference despite its initial apparent superiority. The primary objection relates to partial indexation's exclusion of debt. (The debt exclusion is attributable to complexity and political concerns.) In particular, the debt exclusion creates arbitrage opportunities. Leveraged acquisitions might create excess tax deductions: the borrower's entire nominal interest expense would be deductible while some or all of the offsetting gain on the acquired asset would be excluded. Prior scholarship rejecting partial indexation on arbitrage grounds has failed to assess whether partial indexation would worsen current arbitrage opportunities. This Article therefore undertakes this comparative analysis. While complexities preclude an absolute conclusion, the Article demonstrates why partial indexation, on balance, does not appear to materially worsen tax arbitrage opportunities.

This assessment restores the superiority of partial indexation over the preference. Without materially worsening the arbitrage concerns, partial indexation would maintain a second-best response to lock-in and provide a more precise inflationary response. Another comparative advantage of partial indexation that I analyzed in an earlier article buttresses this conclusion: basis indexation implicitly imposes a tax deferral charge on taxpayers holding appreciated assets. See Mitchell Engler, Partial Basis Indexation: An Implicit Response to Tax Deferral, 53 Tax Law Review 177 (2000).

Finally, in similar comparative fashion, the Article defends partial indexation against concerns of excess complexity and inefficiencies due to the special regime for debt.