End the Inflation Tax

National Review Online

Tuesday, January 10, 2023

 

If there is one thing that Americans understand about inflation, it is that a dollar today is worth less than it was, an unpleasant reality of which they are constantly being reminded as the country approaches the second anniversary of what we were quickly assured was a transitory surge in prices.

 

Most Americans, we suspect, also understand that compounding adds to the force with which inflation corrodes the value of the dollar over time. The period between 2010 and 2020 was one of low inflation. Even so, after adjusting for changes in the CPI, the purchasing power of a dollar had shrunk by just under 15 percent over the period. As of now, the dollar’s purchasing power has shrunk by a total of 27 percent since 2010. Applying those numbers to $100 invested in 2010 (and, for simplicity’s sake, ignoring receipt of interest, dividends, or the like), the investment would have had to have been worth nearly $137 today just to keep pace with prices. But any investors who invested $100 in 2010 and sold that investment today at, say, $125, would be taxed on the nominal gain of $25, even though in real terms they had suffered a loss of $12. A tax on illusory capital gains would, in effect, have been transformed into an all too real inflation tax.

 

Even when investors succeed in outperforming the CPI, some of the gain they make on selling their investment will, absent enough deflation over the relevant period, be nominal, meaning that part of the tax they will be paying on that gain is still an inflation tax. That inflation is, more often than not, the product of policy decisions made in Washington only adds insult to injury.

 

It’s true that that $100 investment would, as noted above, most likely have generated some current return before being sold, but that return would almost certainly have been taxed too. And anyone arguing that many asset classes have performed much, much better than inflation in recent years (2022 was a little trickier) is missing the fundamental point, which is that nominal capital gains are not the same as real return. Investors in the 1970s knew this all too well. In nominal terms, the S&P 500 was roughly 20 percent higher at the end of the decade than at the beginning, but in real terms it had fallen by 40 percent.

 

The inflation tax is inequitable and — by increasing the effective tax rate on capital gains and discouraging long-term investment — destructive. It should be repealed. The best (if somewhat rough and ready) way to do this would be to tax only capital gains in excess of the increase in the CPI over the period an asset is held.

 

Indexation of capital gains has been relatively high on the agenda at various times over the years, including during the Reagan and (briefly) Trump administrations, and ahead of the Republican triumph in the 1994 midterms. With inflation having run at an elevated level since early 2021, increasing numbers of Americans are now having to face sharply higher taxes on gains that do not, in any real sense, exist. Republicans now have a majority, however tenuous, in the House. Any tax plan they advance should include an end to the taxation of phantom gains.