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Capital Gains Taxes and Inflation

1 min readBy: Curtis S. Dubay

Democratic presidential hopeful John Edwards recently released a plan to increase the capital gains tax rate to 28 percent. The current capital gains rate is 15 percent, so Edwards’ plan would nearly double the current rate.

The preferential treatment of capital gains and dividends—both taxed at 15 percent compared to 35 percent for wage and salary income—is sure to be a hot-button issue as the presidential race continues and the Democratic Congress pushes for taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. increases under the pay-go rules.

Democrats will argue for a higher tax rate on capital gains on fairness grounds, and Republicans for a lower rate based on economic growth and efficiency. While agreement on these issues is unlikely, both sides should agree that the portion of capital gains that is due solely to inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. should be removed from the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. .

We released a paper late last year that detailed how inflation can cause the effective tax rate on capital gains to be higher than 300 percent in some years. This is because a portion of an asset’s appreciated value is tied directly to a rise in the general price level.

Gains due solely to inflation hold the original value of an asset and should not be taxed, since they do not increase the asset holder’s ability to consume—the standard economist’s definition of income.

Indexing capital gains to inflation would improve fairness and economic efficiency in the same way indexing the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. brackets has, so it should be something both parties are in favor of.