NCPA - National Center for Policy Analysis

Inflation's Effect On Capital Gains

July 29, 1999

Inflation is at a near-historic low, but there is no guarantee it will not return, economists warn. Even a small increase in inflation would affect investors with capital gains on their portfolios, and they would lose even if Congress and the White House were to agree to reduce capital gains tax rates from 20 percent to 15 percent.

Capital gains are the increase in the market value of a financial instrument, such as stock, over the price paid by an investor. Capital gains are taxed when an investor sells a stock -- thus realizing the gain.

Some economists are urging that, in addition to rates being cut, capital gains be indexed for inflation.

  • Even with that 5 percentage point reduction in rates, all that would be needed to undo the reduction is for the underlying inflation rate to increase by one-third of the nominal rate of return.
  • Using the long-run historical average of a 6 percent to 9 percent nominal return for the stock market, that means a rise in the inflation rate of about 2 percentage points -- to between 4 percent and 5 percent -- would wipe out the proposed capital gains tax reduction.
  • With the Clinton administration forecasting 2 percent inflation for years to come, the static revenue loss to the government from inflation indexing would amount to only 2 percent of the projected capital gains realization.
  • Taking the average realizations for the past six years -- which is 2.4 percent of gross domestic product -- the static revenue loss to the federal government of indexing capital gains would amount to only about 0.05 percent of gross domestic product.

That, experts contend, would be a small price to pay for the economic benefits which would accrue. Among the benefits would be a lessened incentive to lock up investments so as to postpone taxes. And in the event of another bout of inflation, economic growth would not be further hobbled by the disincentive to invest.

Source: Victor Canto (La Jolla Economics), "Index Capital Gains -- Now," Wall Street Journal, July 27, 1999.


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