How One Can Face an Infinite Effective Tax Rate on Capital Gains

January 7, 2015

The current federal top marginal capital gains tax rate in the United States is 23.8 percent (a 20 percent income tax rate plus the 3.8 percent net investment tax from Obamacare). Additionally, states tax capital gains, leading to an average marginal rate around 28.7 percent.

Compared to other industrialized nations, this is a high tax rate. The average across the OECD in 2014 was approximately 18.2 percent (22.9 percent weighted by GDP). 9 countries don’t even tax long-term capital gains. Having a capital gains tax rate this high negatively impacts the economy. It leads to reduced saving, reduced investment, and a smaller capital stock, which adversely affects both the return on capital and workers’ wages.

On top of these issues there is a less-discussed problem with capital gains taxation in the United States: the U.S. does not adjust capital gains for inflation. The result is that an individual will pay tax on his income plus any capital gain that results simply from price-level increases.

For instance, suppose an individual purchased an average stock valued at $7.51 in 1980 and sells this stock in 2013 for $100. As a result, he realized a capital gain of $92.49 and must pay the 23.8 percent tax of $22.01 on this nominal gain. However, since there was inflation during this period, the real gain was actually only $78.79. This implies that the taxpayer paid an effective rate of 27.9 percent on the real gain.

The amount of tax you pay due solely to inflation varies year to year depending on the real vs. inflation gains.

What you’ll notice is that gains realized from stock purchases in some years yield a tax bill entirely from inflation. This means individuals are paying taxes while earning no income.

Suppose you purchased a stock for 89.18 in 2000 and it grew at the same rate of the S&P 500 on average. In 2013, you sold the stock after it has increase in value to $100. Due to your long-term capital gain of $10.82, you need to pay the 23.8 percent tax to the IRS of $2.57.

However, after adjusting for inflation, your $10.80 gain was actually a $4.88 loss. The IRS does not care. You will still end up paying the $2.57 tax. So you will owe tax on a real loss, resulting in an infinite effective tax rate.

The capital gains tax is more damaging than other taxes because of the bias it creates towards consumption over savings and investment. By applying the tax on a nominal basis, many further detrimental effects are caused, including an average effective rate on real capital gains that exceeds the top personal income tax rate, despite the preferential statutory rate capital gains receive. In certain situations, taxpayers face an infinite rate on real capital gains when the tax is solely due to inflation. While repealing this tax would be the preferable option, inflation indexing would be an improvement that would link the tax to real increases in income rather than increases in inflation.

More on capital gains taxation here and here

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