The Bush Capital Gains Tax Cut after Four Years: More Growth, More Investment, More Revenues

Policy Reports | Taxes

No. 307
Thursday, January 10, 2008
by Stephen Moore and Tyler Grimm

Is It Fair to Tax Gains Due Solely to Inflation?

One of the most unfair features of the capital gains tax, noted briefly earlier, is that it taxes gains that may be attributable only to price changes, not real gains.  The capital gains tax, unlike most other elements of the U.S. tax code, is not indexed for inflation, and that can have major distortional effects on what an individual pays in capital gains taxes.  According to the nonpartisan Tax Foundation it can — indeed, often does — lead to circumstances in which investors “pay effective tax rates that substantially exceed 100 percent of their gain.”27

“Inflation causes illusory gains in asset prices.”

Figure IX, from a Tax Foundation report, shows the tax on real gains compared to inflationary gains on a stock purchased in 1956 and sold in each successive year.  The Tax Foundation has found that about $50 billion a year of capital gains in the past decade, or about 20 percent to 25 percent of total gains, have been due purely to inflation.28 It found that in some years during the late 1970s and early 1980s, 100 percent of the gains were due to inflation.  This inflationary effect is one reason that capital gains are taxed at a different tax rate than ordinary income.  The lower rate on capital gains offsets some, but usually not all, of the phantom gains due to inflation.

Tax on Real vs. Inflationary Capital Gains

It is not at all uncommon for taxpayers to pay very high real capital gains tax rates.  Then-Federal Reserve Board governor Wayne Angell calculated in 1993 that the average real tax rate on investments in NASDAQ stocks from 1972 to 1992 had been 68 percent.29 The real tax rate on investments in the Standard & Poor’s Composite Index over the same time period had been 101 percent.  The average real tax on a portfolio of New York Stock Exchange stocks was 123 percent.  And the average real tax on the Dow Jones Industrial Average over that 20-year period was an astounding 233 percent.  In other words, according to three of the four indices, investors paid capital gains taxes on investments that actually lost money after adjusting for inflation — and thus the tax simply diminished the principal. Angell concluded,

If we are to reduce the damaging effects that we know are caused by all capital taxation, it makes sense to eliminate the worst aspect of the most damaging tax on capital — the tax on phantom gains.  The tax on real capital gains is a middle-of-the-road bad tax.  But the tax on nominal capital gains without regard to whether the gain is real or only the effect of inflation is truly the worst tax.30

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