Capital Gains Taxes and Inflation

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 tax 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 inflation should be removed from the tax base.

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 tax brackets has, so it should be something both parties are in favor of.