Issues in the Indexing of Capital Gains for Inflation

October 3, 2006

This morning’s Wall Street Journal makes the case for inflation-indexing capital gains in the federal individual income tax code. From the piece:

Income tax brackets have been adjusted for the cost of living ever since the Reagan tax cuts of 1981 — a historic pro-growth victory. But capital gains continue to suffer from an inflation tax, which yields a windfall profit for the government but reduces the value of holding long-term capital assets.

This situation stretches back to 1913, when the Treasury Department decided to define the word “cost” in the tax code as meaning historical dollars, rather than current dollars. Capital gains taxes are due whenever an asset yields a nominal gain, even if the investment is a loser in real terms. So an investor who purchased a stock for $10 in 1956, and sold it for $20 today, would still pay a 15% capital gains tax on the transaction, even though adjusted for 50 years of inflation he’d be a net loser.

From 1979 to 1994, roughly 33% of the increase in shareholder wealth, or some $1.5 trillion, was due to inflation. This means Americans are paying far higher capital gains tax rates than advertised. A 1993 study by then Federal Reserve Board Governor Wayne Angell calculated that the average real tax rate on investments from 1972 to 1992 in Nasdaq stocks was 68%. It was 101% in the S&P 500, 123% in the NYSE, and 233% in the Dow Jones Industrials. On three of the four major indexes, the average taxes were higher than the actual return. (Full piece here.)

As we’ve written before, taxing the nominal value of capital gains rather than real inflation-adjusted values can lead to effective tax rates on investments that are dramatically higher than statutory rates—often taxing away the full real value of capital gains and more, with rates in excess of 100 percent in some years.

However, capital gains isn’t the only aspect of the federal tax code that’s not inflation adjusted. The alternative minimum tax (AMT) is based on nominal values, as is the deductibility of interest expenses—that is, nominal interest is deductible for businesses as well as real interest paid—and many other aspects of the tax code. Taken together, the task of fully adjusting the income tax for inflation is a tall order indeed.

There are at least two big issues Congress will be forced to wrestle with if they decide to index capital gains for inflation. First, indexing has the potential to greatly complicate the federal tax filing process if not done properly. Anyone who doubts that need look no further than the staggeringly complex process by which federal income tax brackets are adjusted each year, which in principle appears simple. And secondly, some economists have pointed out that a tax code that’s only partly indexed for inflation can create problems of its own, which may be a remedy worse than the disease. Partial indexing—as opposed to wholesale indexing of the entire tax code—could lead some assets to become tax-preferred compared with those that aren’t indexed, potentially creating large economic distortions as a side effect.

Of course, one possible solution that’s been suggested would avoid much of the need for inflation indexing altogether—movement away from the taxation of Haig-Simons income, and toward the taxation of consumption instead.



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