Capital Gains Taxes Should Be Indexed to Inflation

July 23, 2018

Rep. Devin Nunes’ (R-CA) recently introduced bill, H.R. 6444, is the latest effort to index capital gains taxes to inflation. This would be commonsense reform, because inflation-related gains do not represent an actual growth in wealth over time.

Most aspects of income-related taxes are already adjusted for inflation to ensure that individuals are only being taxed on real increases in income, not nominal increases. As my colleague Steve Entin argued earlier this year, extending this policy to capital gains is an important idea.

An example can help illustrate the problems caused by not indexing an investor’s capital gains tax basis. The value of the dollar in the year 2000 held more purchasing power than the dollar in 2018. When an investor purchases an asset, like a share of stock, that asset will likely gain value over time. When that asset is sold at a higher value in the future, a portion of that growth is due to inflation. When that inflation is ignored in the taxation process, the investor gets taxed on gains that they didn’t make.

For example, say an investor put $5,000 in the stock market in the year 2000. Under the current law, if that $5,000 generously turned into $8,000 over those 18 years, they would be taxed on the $3,000 gain, resulting in a tax liability of $450.

The problem is, in 2018, that $5,000 from 2000 is equivalent to roughly $7,100 today. Inflation accounted for $2,100 of that gain. This means the investor only really made $900, not $3,000. Under the new bill, investments would only be taxed on the $900 that was actually earned over that time.

Capital Gains Tax: Indexed vs. Not Indexed to Inflation
Investment in 2000 $5,000   Investment in 2000 $5,000
Value of the sale in 2018 $8,000   Value of the sale in 2018 $8,000
Gains (indexed for inflation) $900   Gains (not indexed) $3,000
Capital Gains Tax (15%) $135   Capital Gains Tax (15%) $450

Even worse, if an investment doesn’t make more than the rate of inflation, the investor is taxed on gains that are not even gains at all. If that investor who invested $5,000 in 2000 sold the investment for $7,000 in 2018, the asset was actually sold at a real loss. However, under current tax treatment, the investor would still have a positive tax liability.

Congress should consider indexing capital gains tax basis to ensure investors are taxed on their actual gain, not inflation.

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