The result is that the aggregate effect of those institutional barriers is offset as investors seek the highest returns available. In this connec tion, it may also be noted that Congress is addressing this issue of removing restrictions on interest rates on savings.

Although market adjustments will always be less than perfect, the theoretical and empirical evidence indicates that inflation is anticipated by lenders and borrowers so that gains and losses are, on the whole, substantially offset and the overall determination of net income is not affected. To create perfect adjustments would require a tax code that would be enormously complicated and impractical. The interactions of the free market result in rates of interest that sufficiently adjust to and anticipate the rate of inflation so that it is unnecessary to index the basis of fixed dollar assets and liabilities.

The Capital Maintenance Deduction for Net Worth

Some countries (most notably Brazil) that have experienced rates of inflation significantly higher than the United States have provided businesses with a capital maintenance allowance designed to compensate business enterprises for the eroded buying power of their equity.

Briefly stated, a capital maintenance allowance is a deduction or adjustment that applies the inflation rate to net worth as adjusted for nondepreciable and nonfinancial assets. Thus, the capital maintenance allowance would be calculated by comparing the beginning and ending net worth of a company after eliminating static assets, such as LIFO inventory, land, goodwill, or other fixed assets which are not adjusted for depreciation. The capital maintenance allowance could be determined at various points during the year or with beginning and ending averages. In a complex and changing economy, we believe that the difficulties in record keeping, administration, and calculation under a capital maintenance provision would outweigh the benefits that might result and therefore conclude that a capital maintenance allowance is not needed at this time.

Estate and Gift Taxes

In 1942, Congress determined that decedents with taxable estates valued at more than $60,000 should pay an estate tax and that persons who made gifts of over $30,000 during their lifetimes (ex

cluding annual gifts of $3,000 or less to each individual donee) should pay a gift tax. At that time, these figures constituted Congress' view of a fair distinction between those who should and those who should not pay a tax on the transfer of their wealth.

From 1942 to 1976, as inflation eroded the value of the dollar, more and more of the population passed over those threshhold amounts. Some became relatively more wealthy, but others, such as wage earners and many farmers and small businessmen, crossed the threshhold only because it is defined in terms of the ever eroding dollar. Their income and assets stated in dollars had grown but their purchasing power had not grown proportionately. As a result, every year a greater number of individuals became subject to these transfer taxes.

When Congress acted in 1976 to reform the estate and gift tax provisions of the Internal Revenue Code, it did little to counteract inflation as a taxing agent. It left the annual gift tax exclusion at $3,000. It did abandon the $60,000 exemption from estate taxation, replacing it with a $47,000 credit against the tax (beginning in 1981). The credit is popularly referred to as the equivalent of an exemption of $176,000, but this is accurate only with respect to the lower end of the estate tax scale. For estates falling into the highest bracket, the $47,000 credit is the equivalent of only about a $67,000 exemption. Prior to the 1976 reforms, the $60,000 exemption reduced taxes by $46,200. Thus, the change did not adequately adjust for inflation. The reduction of the top estate tax bracket from 77 percent to 70 percent was not an adequate response to inflation either; rather, it was a trade-off for enactment of the unified transfer tax, the subsequently revoked carry-over of basis rule, and the generationskipping transfer tax. The unified transfer tax not only raised the gift tax rates as high as those of the estate tax (prior to the 1976 reforms they had been three-quarters of the estate tax) but also provided that taxable gifts be drawn back into the tax base at the time of the donor's death. In addition, the scale of rates was shifted higher, and the top brackets are now reached more rapidly.

The reform legislation relaxed the tax burdens only in a few, selected areas. The smallest estates gained some relief from the new unified credit, the minimum marital deduction, and special valuation methods for real property used as a farm or in a trade or business. However, the limited relief available to these specific hardship cases is fast dwindling. In each case the relief was provided in fixed dollar terms: the $47,000 credit, the $250,000 minimum marital deduction, and the $500,000 maximum decrease of valuation for

qualified farm and small business real property. Consequently, as time passes, inflation shrinks the effectiveness of the relief. At an annual inflation rate of 10 percent, $350,000 in 1988 and $700,000 in 1995 will be needed to furnish the same purchasing power that $176,000 provides in 1981.

Congress ought to establish the level of real wealth that should be subject to the estate, gift, and generation-skipping transfer taxes, and this level should then be maintained by indexation. Inflation should not push individuals not previously subject to transfer taxes above the minimum level of taxation and then ever highter up the scale of transfer tax rates. In an indexed system, only a true increase in wealth would have this effect.

The estate, gift, and generation-skipping transfer tax provisions are readily subject to indexing in the same manner as income tax brackets and fixed dollar amounts. The upper and lower boundaries of each tax bracket and the credit for state death taxes can be modified annually by reference to cumulative changes in the CPI. In similar fashion, the applicable fixed dollar amounts may be adjusted for inflation. The inflation factor determined annually should be applied to amounts such as the following:

1. The unified credit against estate and gift taxes, and, to the extent available, against the generation-skipping transfer tax.

2. The $500,000 limit on decrease of valuation for qualifying farm or other trade or business real property.

3. The $500,000 limit on decrease in the value of the gross estate in recognition of material participation in a farm or other trade or business by the surviving spouse.

4. The $250,000 minimum marital deduction.

5. The orphan's exclusion, presently $5,000 for each year that a child is younger than twenty-one.

6. The annual exclusion of gifts up to $3,000 to each donee.

7. The limit of $5,000 upon the exclusion from gift taxation of a general power to appoint property.

8. The limit of $100,000 on excludable gifts to a spouse.

9. The $250,000 limit on excludable generation-skipping transfers.

In the case of estate and gift tax provisions, the due dates of the returns permit reference to CPI figures at the close of the calendar year rather than to those of the third quarter, as would be necessary for income tax purposes. Furthermore, we recommend no more

than annual adjustment. Although the taxes apply to transfers at particular moments in time, the reference to a figure which applies to an entire calendar year would be a simple process and would be sufficient to relieve the problem to which indexation is addressed.

No adjustments are recommended to the amounts of prior gifts or taxes paid thereon. Since these amounts generally are reciprocal their indexation would serve little practical purpose. Thus, only the unused portion of the unified credit would be indexed. This refers to amounts such as the following, which would not be indexed:

The amount of adjusted taxable gifts taken into account in computing the tentative estate tax and the amount of the credit against the estate tax for gift taxes paid by the decedent.

⚫ The aggregate sum of the taxable gifts and the gift taxes of preceding years taken into account in computing the gift taxes of a particular year.

The amount of the credit against the estate tax for taxes paid on a prior transfer to the decedent.

Measurement of Inflation

The AICPA believes that the index used to measure inflation should be readily accepted by broad segments of society and should be capable of being consistently applied. Further, we support the use of a single general purpose index. Although arguments have been made that an indexation system should use different indexes for different items so that alternative indexes could be used for specific applications, we believe this would add complexity to the tax code.

An index such as the Consumer Price Index (CPI) would generally meet these requirements. The CPI is a widely used measure of inflationary pressures and of changes in the purchasing power of the consumer dollar. It is the most familiar index, and it is currently used in the Internal Revenue Code and by various states that have adopted indexed tax systems. In addition, among the countries that use indexation in their tax structures, nearly all make use of their equivalent of the CPI. While imperfect, the CPI generally reflects price changes for things people must buy in order to live-food, clothing, rent, household supplies, medical expenses, public utility rates, and so on. 15

15. U.S., Department of Labor, BLS Handbook of Methods for Surveys and Studies (Washington, D.C.: Government Printing Office, 1976), p. 88.

All statistical surveys, by nature, lend themselves to possible inaccuracies, and the CPI as a general measurement of inflation has been criticized for a number of reasons. Shortcomings of the CPI may arise from inaccurate reporting, lack of systematic incorporation of new outlets into the sample, and introduction of new products or changes in product quality. 16 It should also be noted that the CPI has not been developed for use in measuring nonconsumer price level changes.

However, the public generally considers the CPI the official government indicator of inflation. It has widespread use in wage and collective bargaining negotiations. An index based on the CPI is used for Social Security payments and for fixed dollar limitations for defined benefit plans and defined contribution plans.

In conclusion, we believe that a single generally accepted and consistently applied index should be used. Whatever index is selected, it is important that it be continually monitored and adjusted to reflect changes in the economy.

16. Edward Meadows, “Our Flawed Inflation Indexes,” Fortune, 24 April 1978, p. 67.