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Capital Gains Tax Reform

01/25/08 7:55AM By Dick Mallary
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(HOST) Commentator Dick Mallary is a former U-S congressman from Vermont who has served extensively in state government, including a turn as state tax commissioner in 2003. He's been following the current discussion about Capital Gains Tax Reform and has some thoughts of his own on the subject.

(MALLARY) I was surprised to learn of Governor Douglas' proposal in his State of the State Address to change in Vermont's system for the taxation of long-term capital gains.

Under present law, when a person sells at a profit property that he has owned for more than one year, the increase is considered a long-term capital gain. Under Federal law, most such gains are taxed at a significantly lower rate than most other income. When Vermont decoupled its income tax from the Federal Code, it continued the favorable treatment of long-term capital gains by providing that the recipient of such gains could exclude 40% of those gains when calculating his Vermont taxable income. It is this exclusion that the Governor proposes to eliminate.

The Governor appears to misunderstand the current situation when he says in his address that "our current tax structure taxes earned income - at a higher rate than it taxes unearned income." I won't quibble as to whether capital gains technically constitute income, but there is no question that most unearned income -- interest and dividends and short term capital gains -- are taxed by Vermont at exactly the same rate as earned income. Only long-term capital gains receive a favored treatment, and there are good reasons for that treatment.

One important reason for special treatment is to promote the economy by encouraging savings and investment. But, I will leave it to the economists to defend this aspect of the special treatment.

My concern is to assure fairness and equity in the treatment of all taxpayers. In many cases, long-term gains from the sale of property represent nothing more than the result of inflation. If a person bought a stock or bought a business or inherited a farm in 1984 and sold it in 2007 for twice its 1984 cost or value, all of the increase would be the result of inflation. There would be no real gain in purchasing power. If, as the Governor proposes, we tax such phantom capital gains at the same rate as other income, we will be truly unfair to those who have owned and held property for a long time

The fair solution to this problem may not be easy to administer, but it is clear and direct. It is not to provide special treatment for selected people by exempting taxpayers such as those over 65 or those with special kinds of property such as farmers. What we should do is to index capital gains for inflation so that only the true gain or profit in today's dollars would be subject to tax. I agree that Vermont should eliminate its present arbitrary 40% exclusion of long-term capital gains; but only if, at the same time, it stops taxing any gains that are solely the result of inflation. By enacting such a change, the Governor can achieve his goals of greater fairness in taxation while also probably increasing revenues for the state.
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