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Senate Bill's Stealth FIFO Capital Gains Hike Hinders Tax Reform

It’s crunch time on tax reform! The House passed a bill just before Thanksgiving. Now it’s the Senate’s turn. A good tax reform bill would be one that lowers rates, reduces complexity, and gets rid of special privileges in the tax code.

Unfortunately, the Senate’s tax reform bill has a provision that runs counter to these principles of lowering and simplifying taxes for ordinary folks. The legislation that passed the Senate Budget Committee yesterday, and may go to the floor later this week, contains a stealth tax hike that would add massive complexity and confusion to tax filing.

Since the beginning of the federal income tax, individuals who made multiple purchases of stock in a company could choose which tax lot they use as a basis when selling the stock and figuring any capital gains tax. In other words, if a taxpayer bought a lot of 100 shares in a company at three different times for $25, $30, and $35 per share, and then sold 100 shares at $40 per share, he or she could subtract whichever purchase price he or she desired. Since the highest purchase price would bring the lowest capital gains tax, most taxpayers would subtract the purchase they made at $35.

But the Senate bill has a first-in, first-out (FIFO) provision that requires taxpayers selling stock to use their earliest purchase of that stock as the basis to calculate capital gains. The Joint Taxation Committee estimates that this provision will bring in $2.7 billion. This is relatively small considering compared to the costs and revenues from the bill’s other provisions. And even this may overestimate the revenue the provision would bring in, as individuals are less likely to sell stock if capital gains taxes go up.

Stephen Entin, senior fellow at the Tax Foundation who was Deputy Assistant Secretary for Economic Policy in the Reagan administration, writes that “although the provision is estimated to raise only a small amount of money, it will affect the management of several trillion of dollars of individual and mutual fund assets.” He concludes, “The inconvenience-to-revenue ratio seems very high.”

In addition to the cost, this provision would add much complexity to calculating capital gains taxes for both investors and the brokerage firms that serve them. And it would entail probable privacy invasions to enforce. This is because many taxpayers hold the same stock in different accounts. A taxpayer could sell stock from one brokerage account from which he or she first bought shares in a different account, including one that is held jointly with a spouse. Enforcing the provision may require to government to rummage through all these accounts.

The provision exempts mutual funds, but this could result in significant distortions in the economy. There could be a windfall for the large companies in mutual funds, while investment in startups shrinks.

All in all, this provision imposes massive harms in return for very little revenue and is not consistent with principles of tax reform.