Inflation Leads to High Effective Capital Gains Tax Rate

January 8, 2014

Inflation can lead to an infinite effective tax rate on capital gains, say John Aldridge and Kyle Pomerleau of the Tax Foundation.

The capital gains tax slows growth and constitutes a double tax on corporate profits; any time stock is sold above its purchase price, the gain from that sale is taxed.

Capital gains may be largely due to inflation. However, the capital gains tax does not take this fact into account and instead taxes the nominal (that is, not adjusted for inflation) gain. This means that the effective tax rate on the capital gain (the real gain, indexed for inflation) exceeds the statutory rate.

  • Every year since 1950, the effective tax rate has exceeded the statutory rate, averaging around 42 percent.
  • This practice can actually result in an infinite effective rate of tax on real capital gains when price increases are due only to inflation.
  • Any purchases of an average stock from 1999, 2000 or 2007 that are sold in 2013 would be taxed 100 percent on inflation.
  • Some nominal gains are actually real losses.
  • In fact, individuals who bought stock at the peak of 2000 or 2007 and sold the stock in 2013 actually experienced a capital loss.

Repealing the capital gains tax altogether would be the ideal solution to this problem, and it would end the bias against investment and produce economic growth. If repeal is impractical, taxpayers should at least be able to index the basis of their gain to inflation in order to determine their real capital gain.

Source: John L. Aldridge and Kyle Pomerleau, "Inflation Can Cause an Infinite Effective Tax Rate on Capital Gains," Tax Foundation, December 17, 2013.

 

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