Inflation Report Reminder: Capital Gains Must Be Indexed

By SBE Council at 12 December, 2018, 11:12 pm

by Raymond J. Keating-

The latest news on Consumer Price Index (CPI) inflation from the U.S. Bureau of Labor Statistics was good. After a blip up (+0.3 percent) in October, the CPI remained unchanged in November.

And over the past year, CPI inflation ran at only 2.2 percent.

Sometimes people forget that low inflation is good news for the economy in terms of investment. After all, inflation itself is a tax, as it diminishes the value of the dollar. That is, inflation creates uncertainty as to what the future value of the dollar will be. That obviously restrains investment.

For good measure, since capital gains are not indexed, inflation increases the real capital gains tax rate. For example, the current nominal top federal capital gains tax rate on individuals stands at 23.8 percent. But consider what inflation does to the real capital gains tax rate.

Let’s take an example of a $1,000 investment that rises to $1,403 five years at a 7 percent annual return. It is sold for a nominal capital gain of $403, with a capital gains tax of $96 resulting from the 23.8 percent rate. That tax already is too high given the importance of entrepreneurship and investment to economic, productivity, income and job growth, but when inflation is factored into the equation, the real rate rises much higher.

Even at a tame 2 percent annual inflation rate, the real capital gains tax rate on this investment jumps to 32.3 percent. At 3 percent annual inflation, the real tax rate is 39 percent, and at 4 percent annual inflation, the real capital gains tax rate hits 48.2 percent. That’s more than double the stated nominal rate.

So, yes, inflation matters a great deal when it comes to investment incentives.

This example should point us to two policy measures. First, the Federal Reserve’s exclusive focus should be on price stability. Second, Congress should index capital gains for inflation, thereby bringing the real capital gains tax rate in line with the stated nominal rate.

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Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.