Testimony of Herbert J. Lerner Chairman, Tax Policy Subcommittee Statement of American Institute of Certified Public Accountants Before the Taxation and Debt Management Subcommittee August 1, 1983 My name is Herbert J. Lerner, and I am the Chairman of the Tax Policy Subcommittee of the Federal Tax Division of the American Institute of Certified Public Accountants. I am pleased to appear today to support Senator Armstrong's indexation bill, S. 1600. My comments reflect the views of the AICPA, which represents approximately 200,000 certified public accountants throughout the United States. In their practices, CPAs apply the tax laws to a myriad of real life situations. We are in a unique position to observe the practical effects of these laws and believe that we have a responsibility to try to help improve the tax system. Periodically, we publish Statements of Tax Policy which provide our perspective and analysis of major national tax policy issues. One such issue was addressed in Tax Policy Statement Number 9, "Implementing Indexation of the Tax Laws," a copy of which is appended to my statement for inclusion in the record. Senator Armstrong's indexation bill is generally consistent with the recommendations of our Statement, in that it provides for the indexation of the basis of assets to minimize the impact of inflation on the tax system. His bill, coupled with the 1985 indexation of tax rates, the zero bracket amount, and personal exemptions, as enacted by the Economic Recovery Tax Act of 1981, represents an important step toward comprehensive indexation and resulting greater equity. The 1981 Act changes represented a major endorsement by the Congress of the concept of indexation of our tax system as it relates to the individual income tax. But it was limited to indexation of tax rates--not indexation of the tax base. It will eliminate the concerns about "bracket creep" for most individuals who derive their income from inflated rates of current salaries, wages, etc. But the 1981 Act will have limited effect on those who derive inflation-induced gains from the sale of an asset held for many years. The individual who derives gain from such a sale in 1985 may or may not be affected by the rate bracket, etc. adjustments (if any) for that year, and it would only be coincidental if the rate bracket adjustment bore any relationship to the distortion of real income realized on the sale of the property. The 1985 indexation of rates only serves to preserve the rate structure established for 1984 by avoiding inflation induced changes. It does not attack the fundamental issue of how to protect individuals from taxation when there has only been nominal gain realized due to prior inflationary years. Indexation of the tax basis of property is, we believe, the solution to that problem. Some have argued that indexation of basis is not necessary because of the 60 percent exclusion of long-term capital gains from taxable income. We believe that the current or any such similar exclusion is neither an equitable nor an adequate method of compensating for inflation. Despite the exclusion, taxpayers who have suffered a real economic loss often are subject to tax on the sale of an asset. A simple example will illustrate this point. A 9 percent nominal gain on the sale or exchange of an asset held for more than one year during which time inflation was 10 percent, will result in an economic loss of 1 percent. Under our present tax structure, however, the taxpayer would be required to pay tax as if a 3.6 percent taxable gain (40% of 9%) had actually been realized. The inequity is apparent. Indexing the tax basis of assets for gain or loss, or for cost recovery purposes, need not be unduly complex. The unadjusted basis of each asset would be multiplied by a factor which would establish the newly calculated indexed basis to be used for determining gain or loss on disposition. In the interest of tax simplification, index factors might be determined on an annual basis, rather than quarterly. The use of an indexed basis would result in the calculation of gain or loss on the sale of assets that would be consistent with the underlying economic effect. Although excluded from Senator Armstrong's bill, we believe that indexation also should apply to tangible personal property and to the basis of assets for calculating depreciation. Depreciation charges based on unadjusted historical costs are unrealistic when they are compared with current replacement costs. Under an indexed system of depreciation, the accelerated cost recovery percentage could be applied to the indexed basis to calculate the taxpayer's depreciation deduction. Besides current tax rules pertaining to depreciation, new ones could be applied. The system of open-ended or "pooled" accounts, with which several of the Senators are familiar, is particularly well-suited to indexation. Furthermore, the indexation of basis need not affect the determination of the period over which capital costs would be recovered. While use of an indexed basis for calculating depreciation would make it possible to recover more than 100 percent of the original cost through depreciation deductions, it would reflect economic reality and aid investors in dealing with the rising replacement costs of capital assets during inflationary times. I call the Subcommittee's attention to the other indexation recommendations contained in our Tax Policy Statement and to the recommendations made in our various other tax policy statements. For example, our Statement of Tax Policy on Indexation also recommends all fixed-dollar allowances or exemptions in the Code should be indexed to |