The United States’ federal top capital gains tax rate is now 23.8 percent due to two tax increases at the start of 2013. This is problematic, because the capital gains tax creates a bias against savings, slows economic growth, and places a double-tax on corporate profits. Although these problems with the capital gains tax are well known, there is a more subtle issue with the tax that makes it even worse for taxpayers than these conventional concerns suggest.
Under the federal tax code, the increase in an asset’s price is determined as the nominal amount (i.e., not adjusted for inflation). When an asset (often a stock) is sold above its purchase price, a gain is realized and is taxed. Any capital gain due to inflation is not accounted for, and the taxpayer is taxed on both the increase in income and on increases in prices economy-wide. As a result, the effective tax rate on the real (inflation indexed) capital gain has exceeded the statutory rate every year since 1950 and has averaged around 42 percent.
In some instances, the practice of taxing the nominal gain can lead to an infinite effective rate on real capital gains when the increase in price is due only to inflation. In fact, if a taxpayer purchased an average stock in 1999, 2000, or 2007 and sold in 2013, they would be taxed entirely on inflation.
Apparent Gains, Real Losses
Over the past 60 years, the stock market has grown immensely in nominal terms. In nominal terms, the S&P 500 grew from $18.43 in 1950 to $1,601.15 in 2013, an increase of 8,587 percent. Most of the growth of the S&P 500 happened in the 1990s when the value of the index grew from $332.68 in 1990 to $1,419.73 in 2000, a 327 percent increase. In the 2000s, the market became volatile, crashing from a record high twice, though it still nominally grew to its highest point in history in 2013. This means if an individual purchased an average stock any year between 1950 and 2012 and sold it in 2013, the person would have realized a nominal capital gain.
However, after adjusting the value of the S&P 500 for inflation, some of these nominal gains become real losses. While it is true that from 1950 to 2013, the S&P 500 still experienced tremendous growth of about 800 percent, it actually peaked in 2000 in real terms and has yet to recover from its two crashes in the 2000s. In other words, individuals who purchased stock at or around the peaks of 2000 and 2007 actually realized a real capital loss if they sold the asset in 2013.
When an individual buys a stock and later sells it for a capital gain, they must pay tax on this income. 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.
However, the amount of tax owed due to inflation or a real gain is not the same each year. The proportion of tax due to inflation varies year to year. For instance, if a taxpayer purchased an average stock in 1950 and sold it in 2013 for $100, she would pay a $2.39 tax on inflation and $21.14 on a real gain. In contrast, a taxpayer who purchased an average stock in 1967 and sold it in 2013 for $100 would pay $8.22 on inflation and $14.20 on a real gain.
Taxes on Inflation, not Income
When stocks are bought at particular high points in the market, inflation can account for 100 percent of the capital gains tax owed. In fact, the inflationary increase in price can cause a nominal capital gain for a taxpayer despite suffering a capital loss in real terms. The tax paid on inflation as a percent of a taxpayer’s total tax bill is relatively small if the stock were bought in the 1950s or in the 1980s due to the real increase in the value of the market since those decades. In contrast, the average stock bought in 1999, 2000, or 2007 would yield real losses if sold in 2013 but nominal gains on the order of 19.6, 12.1, and 7.7 percent respectively. The capital gains tax owed on the average stock bought during these years is solely due to inflation.
Because inflation has been an ever-present phenomenon in the economy, it has affected the taxes owed on long-term capital gains every year since 1950. As a result, the effective rate on real capital gains has exceeded the statutory rate every year since 1950. The effective rate on real gains varied between 26.4 percent for a stock purchased in 1950 and 309 percent for stocks purchased in 1998. For stocks purchased in 1999, 2000, and 2007, the nominal price of the stock increased while the real value declined. As a result, the effective rate is infinite. The average effective rate on real gains from 1950 to 2012 was 42.5 percent, nearly twice the statutory rate.
Taxpayers can end up paying a very high tax rate on capital gains and can even pay taxes on capital gains when the real value of their investment has actually declined. In fact, research from the 1980s showed that taxpayers paid an additional $500 million in extra tax due to inflation in just 1973. Taxes on capital damage economic growth, and failing to account for inflation exacerbates the damage. Outlined below are some possible solutions to the problem.
Repealing the Capital Gains Tax
In order to stop the damaging practice of taxing individuals on inflation, one solution would be to repeal the capital gains tax altogether. In an ideal world we would eliminate both the capital gains tax and the dividends tax as they create double taxation. High taxes on capital cause lower overall investment and higher consumption. This tax bias toward consumption over investment slows economic growth over the long term.
Repealing the capital gains tax would be a pro-growth change and produce positive long-term dynamic effects for the economy. A decrease in the cost of capital would increase the amount of capital available for investment, improving the productivity of business and raising average wages.
Indexing Capital Gains
However, outright repeal of the capital gains tax may be politically impractical. In this case, the second-best solution would be to index capital gains to inflation. While keeping the current tax on capital gains in place, taxpayers could be able to index the basis of their gain to inflation. In order to index the long-term capital gains tax, applicable inflation ratios stretching back several years would need to be determined annually so that the taxpayer could adjust the basis (purchase price) of the asset in order to compute their real capital gain. This would not be so different from the inflation factor the IRS determines annually for calculating the increase in brackets, thresholds, and deductions for the personal income tax.
Capital gains historically have been given a preferential rate over ordinary income, and there has been some discussion that this lower rate exists to account for the lack of inflation indexing. This argument is not logically consistent becase some taxpayers still end up being taxed on real losses, and the average effective rate on real capital gains of 42.5 percent is higher than the top personal income tax rate of 39.6 percent. The motives behind lower rates on capital gains are separate from the impact of inflation on the tax. Indexing would address the current disconnect between the tax levied and whether the taxpayer actually made a profit or loss.
Unfortunately, this alteration to the tax code would bring more complexity. There is already an excess of rules with regard to determining the correct basis and sales price in addition to the types of assets and transactions to which the tax applies. The additional inflation adjustment would complicate the code even further. Inflation indexing would also accentuate the periodic nature of the revenues from this tax, which results from the business cycle, because there would be far fewer real capital gains than nominal capital gains during a recessionary period.
Indexing Good, Repealing Better
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.
Tax Foundation Fiscal Fact No. 406, “Inflation Can Cause and Infinite Effective Tax on Capital Gains,” John L. Aldridge and Kyle Pomerleau: heartland.org/policy-documents/inflation-can-cause-effective-infinite-tax-rate-capital-gains