The capital-gains tax can be thought of as two different taxes: a tax on real increases in asset values and a tax on nominal, inflationary increases in asset values. That inflation tax, levied on the phantom gains in asset values due to inflation, is one of the most unfair and economically destructive taxes the federal government levies. With inflation having nudged upward of late, there is a renewed urgency to repeal the tax.
Let’s say that in 1970 you bought an asset for $1,000 and you sold it today for $4,000. Under current law, you would owe the government tax on a $3,000 capital gain. But in reality you would owe that tax on an investment that had lost value in real terms — in other words, your $1,000 in 1970 would have had greater purchasing power than $4,000 does today. It’s in this way that you can lose real money on an investment and still owe capital-gains taxes. In this example the tax is not really a capital gains tax at all, but an inflation tax.
A 1995 study by Arthur Hall at the Tax Foundation measured the impact of the inflation tax on an average stock (based on the S&P 500) bought in the forty years before 1994 and sold that year. For many of these time periods, Hall found that inflationary gains well outpaced real gains, creating effective tax rates on real capital gains that were consistently higher than the then-statutory rate of 28 percent, and often higher than 100 percent, which is to say the tax liability was greater than the real capital gain.
I reproduced Hall’s methodology to look at the inflation tax on stocks purchased over the past fifty years and sold today. The results were not as striking as those reached in Hall’s analysis, due to the large real stock gains and relatively low inflation of the past decade. Even so, a significant portion of the stock market capital gains over the past decade have been due to inflation. For instance, inflation accounts for fully 48 percent of the increase in value of an average stock purchased at the end of August 1997 and sold today. Inflation accounts for 56 percent of the gain from August 1998 to present. For just the past year, inflation accounts for about half of the price increase of an average stock. Thus, even for assets purchased during the relatively low-inflation 2000s, the real effective capital-gains tax rate is as much as double the statutory rate of 15 percent.
Stock markets were essentially flat in real terms for decades prior to the Reagan economic program of sound money and tax-rate reductions that triggered the long boom. One reason for the poor stock market performance of the 1960s and 1970s was the bite of the inflation tax, which imposed a major tax penalty on investors who generally did no better than break even in real terms.
In 1993, Federal Reserve Board governor Wayne Angell put it best: “If we are to reduce the damaging effects that we know are caused by all capital taxation, it makes sense to eliminate the worst aspect of the most damaging tax on capital — the tax on phantom gains.”
Fortunately, new legislation sponsored by Reps. Mike Pence (R., Ind.) and Eric Cantor (R., Va.), H.R. 6057, would repeal the inflation tax. The bill would index the tax basis for an asset to inflation, taxing only real gains, not inflation. With the burgeoning investor class making up more than half of voters, this basic fairness issue is sound politics as well as policy. Pence-Cantor is a bill that should become a law.
If Congress fails to act, then the president should instruct the Treasury Department to use its rulemaking authority to index the capital-gains tax. The Internal Revenue Code specifies that the tax is levied on the value of an asset at the time it is sold less its cost, which current regulations interpret as its nominal purchase price. But the code does not define the word “cost,” and interpreting it in real economic terms is certainly reasonable; this is the standard courts use to review the department’s discretion. In 1992, Charles Cooper, a former Reagan assistant attorney general, urged the first President Bush to do precisely this in a well-reasoned Wall Street Journal op-ed. Fourteen years later it is high time the second President Bush end this unfair inflation tax.
– Mr. Kerpen is a policy analyst in Washington. His web site is PhilKerpen.com.