INFLATION AND THE TAX MAN

January 18, 2008

All of the Republican candidates have called for low or lower taxes on capital gains, while the Democrats favor higher capital-gains taxes.  But inflation-indexing of capital gains should be part of every candidate's "economic stimulus" package, regardless of party affiliation, says Richard W. Rahn, chairman of the Institute for Global Economic Growth and an adjunct scholar at the Cato Institute.

For instance:

  • Accounting for inflation in this way has the advantages of producing more short-term revenue to the Treasury as long-term gains are "unlocked."
  • Furthermore, lowering the cost of capital would stimulate investment and the stock markets, and would increase the fairness of the tax system by not taxing phantom gains for people at all income levels.

Too few members of Congress have a basic understanding of economics.  As a result, they do not readily see how small but steady losses in value over long periods are damaging, says Rahn:

  • Inflation of 2 percent, 3 percent or 4 percent per year may seem trivial, but over time it causes great distortions.
  • The U.S. dollar is now worth less than 1/20th of what it was worth in 1913 when the Fed was established.
  • If the 12 percent inflation the United States experienced in 1979 had continued, the price level would have doubled every six years.

Adjusting capital gains for inflation would clearly increase revenues in the short run because of the "unlocking" effect, and probably over the long run because of the higher levels of investment it would stimulate, says Rahn.  Over the past 30 years, the Joint Tax Committee, using largely static models, has consistently erred grossly -- at times even getting the direction of the plus or minus sign wrong -- in forecasting capital-gains tax revenues as a result of tax-rate changes.

Source: Richard W. Rahn, "Inflation and the Tax Man," Wall Street Journal, January 17, 2008.

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