Tax Real Gains, Not Inflationary Ones

In his recent column for Forbes, Bruce Bartlett has some good advice for those seeking to preserve low rates on capital gains--an indexing provision that differentiates real gains versus inflationary ones. With anticipated inflation around the corner, this may be a fight worth pursuing...

Some will say that paying 15%, the current capital gains tax rate, isn't much of a burden. But this ignores the fact that over time a lot of capital gains simply represent inflation. The late economist Robert Eisner calculated that the $3 trillion in nominal gains between 1946 and 1977 didn't even compensate for inflation over that period. Investors actually had a loss of $231 billion when their assets were adjusted for inflation.

This led Princeton economist Alan Blinder to conclude that "most capital gains are not gains of real purchasing power, but simply represent maintenance (or rather partial maintenance) of principal in an inflationary world."

This observation is confirmed by more recent data. According to a Congressional Budget Office study, taxpayers realized $72 billion in net nominal gains in 1993. But when adjusted for inflation, this gain actually represented a loss of $19 billion. And all of the real gains were realized households with incomes above $200,000. All other income classes suffered real losses yet still had to pay capital gains taxes.

The Joint Committee on Taxation did an analysis of corporate stock realizations in 1994. It found that the longer the stock had been held the greater the inflation component of the gains. On assets held for 16 years, inflation represented 112% of the realized gains.

The latest research on this issue was done by the Tax Foundation in 2006. It looked at a share of stock in a Standard and Poor's 500 index fund in 1956 and how much of the realized gain represented inflation each year through 2006. Over that period, the price level increased six times, so there was no real gain unless the nominal gain was greater than 600%.

Looking at the tax law in effect in each year, the Tax Foundation found that the effective capital gains tax rate on real gains greatly exceeded the statutory rate in every year. In some high inflation years the effective rate was greater than 100%.

For many years, economists have advocated indexing capital gains for inflation so that taxes would apply only to real gains. Both Robert Haig and Henry Simons, originators of the standard definition of income for tax purposes (commonly known as Haig-Simons), believed that capital gains taxes should apply only to real gains, not to those that simply represented inflation.