Inflation Jacks Up the Capital Gains Tax – President Biden’s Proposal Would Make It Worse

By SBE Council at 4 March, 2022, 12:39 pm

SMALL BUSINESS INSIDER

by Raymond J. Keating –

It’s often said that inflation is the hidden tax. That is true, as inflation, which is an ongoing increase in the general price level, eats away at the purchasing power of the dollar. Inflation means that a dollar tomorrow is worth less than a dollar today.

But there’s more to say about inflation and overt taxation. Inflation actually can increase income-based taxes, for example, when those taxes are not indexed for inflation.

Federal personal income tax rates are indexed for inflation in order to avoid bracket creep.

Bracket creep? That’s when inflationary gains in income push individuals into higher tax brackets (paying higher tax rates). So, a person winds up paying a higher tax rate not due to real gains in income but simply due to inflation.

Capital Gains Not Indexed for Inflation

Unfortunately, capital gains are not indexed for inflation. That means that the real capital gains tax rate that individuals pay actually is higher than the stated nominal rate, which is 23.8 percent (20 percent plus the 3.8 percent Obama Medicare tax). And the hotter that inflation runs, the higher the real capital gains tax rate.

Let’s consider a few examples based on the fact that inflation (as measured by the Consumer Price Index) from January 2021 to January 2022 ran at 7.5 percent. If a person invested $1,000 in a business in January 2021 and sold it in January 2022, the gain, again, would be subject to the 23.8 percent capital gains tax.

Based on the return and the rate of inflation, the real capital gains tax rate changes.

Example #1: Capital Gains Tax Paid on a Real Loss. A $1,000 investment in January 2021 is sold in January 2022 for a gain of $50, or 5 percent. The capital gains tax paid at a rate of 23.8 percent would be $11.90. However, under this scenario and given the increase in inflation, it turns out that this investor is paying capital gains taxes on a real capital loss.

Example #2: A Real Capital Gains Tax Rate of 96.4 Percent. A $1,000 investment in January 2021 is sold in January 2022 for a gain of $100, or 10 percent. The capital gains tax paid at a rate of 23.8 percent would be $23.80. However, under this scenario and given the increase in inflation, it turns out that this investor is paying a real capital gains tax rate of 96.4 percent.

Example #3: A Real Capital Gains Tax Rate of 38.2 Percent. A $1,000 investment in January 2021 is sold in January 2022 for a gain of $200, or 20 percent. The capital gains tax paid at a rate of 23.8 percent would be $47.60. However, under this scenario and given the increase in inflation, it turns out that this investor is paying a real capital gains tax rate of 38.2 percent.

President Biden’s Capital Gains Tax

By the way, President Biden and others in Congress favor increasing the nominal capital gains tax rate, with Biden having proposed a top capital gains tax rate of 43.4 percent on high-income earners. How would these three examples change had the Biden tax rate been in effect?

Example #1: Capital Gains Tax Paid on a Real Loss. A $1,000 investment in January 2021 is sold in January 2022 for a gain of $50, or 5 percent. The capital gains tax paid at a rate of 43.4 percent would be $21.70. However, under this scenario and given the increase in inflation, this investor would be paying capital gains taxes – substantially more in taxes than under current law – on a real capital loss.

Example #2: A Real Capital Gains Tax Rate of 175.7 Percent. A $1,000 investment in January 2021 is sold in January 2022 for a gain of $100, or 10 percent. The capital gains tax paid at a rate of 43.4 percent would be $43.40. Under this scenario and given the increase in inflation, it turns out that this investor would be paying a real capital gains tax rate of 175.7 percent.

Example #3: A Real Capital Gains Tax Rate of 69.6 Percent. A $1,000 investment in January 2021 is sold in January 2022 for a gain of $200, or 20 percent. The capital gains tax paid at a rate of 43.4 percent would be $86.80. However, under this scenario and given the increase in inflation, it turns out that this investor would be paying a real capital gains tax rate of 69.6 percent.

The Democrat’s House Ways and Means Capital Gains Tax

The House Ways and Means Committee also has proposed to increase the capital gains tax, with a top tax on high-income earners of 31.8 percent. How would that rate look in real terms if it had been in effect?

Example #1: Capital Gains Tax Paid on a Real Loss. A $1,000 investment in January 2021 is sold in January 2022 for a gain of $50, or 5 percent. The capital gains tax paid at a rate of 31.8 percent would be $15.90. Again, under this scenario and given the increase in inflation, this investor would be paying capital gains taxes on a real capital loss.

Example #2: A Real Capital Gains Tax Rate of 128.7 Percent. A $1,000 investment in January 2021 is sold in January 2022 for a gain of $100, or 10 percent. The capital gains tax paid at a rate of 31.8 percent would be $31.80. Under this scenario and given the increase in inflation, it turns out that this investor would be paying a real capital gains tax rate of 128.7 percent.

Example #3: A Real Capital Gains Tax Rate of 51.0 Percent. A $1,000 investment in January 2021 is sold in January 2022 for a gain of $200, or 20 percent. The capital gains tax paid at a rate of 31.8 percent would be $63.60. And under this scenario and given the increase in inflation, it turns out that this investor would be paying a real capital gains tax rate of 51.0 percent.

Where Tax Policy Should be Headed: Index Capital Gains and Cut the Tax Rate

It must be understood that the capital gains tax is particularly destructive given that it is a direct tax on the returns on entrepreneurship and private investment, which are vital to U.S. economic, income and employment growth, while also being endeavors that are fraught with uncertainty and risk.

When it comes to starting up, building, operating and investing in businesses, the opportunity for significant returns, again given the levels of uncertainty and risk, must be present. The capital gains tax reduces such potential returns.

As for those who argue that it is somehow harmless to raise the capital gains tax on high-income earners, it must be pointed out that it is, in fact, high-income earners who have the accumulated capital available to invest in new and expanding businesses. Discourage them from investing due to higher taxes, and it turns out that entrepreneurs and their employees are harmed.

Increasing the capital gains tax, as proposed by President Biden and assorted Members of Congress, is counter-productive if we are serious about new business creation, economic recovery and expansion, and increased job opportunities and wages.

Indeed, rather than seeking to increase capital gains taxes, a sound first policy step, as evidenced by the above arguments and examples, would be to index capital gains for inflation, thereby reducing the real capital gains tax rate – with more significant effects during periods of high inflation. After indexing, substantially reducing capital gains tax rates would further enhance incentives for entrepreneurship and investment.

UPDATE: Washington State Judge Tosses New Capital Gains Tax. As we reported back in early January, Washington state lawmakers in 2021 voted to impose a capital gains tax on individuals even though a state constitutional requirement prohibits graduated income taxes. Legislators and the governor simply tried to rename a capital gains tax from an income tax to an excise tax. If the tax was implemented it would have increased the capital gains tax from 0 percent to 7 percent, applied to Washington long-term capital gains in excess of $250,000 for individuals and couples; and was scheduled to go into effect of January 1, 2022.

As noted in this US News article, in a March 1 decision: “Douglas County Superior Court Judge Brian Huber agreed with opponents of the new tax who had argued it was a tax on income that violates previous state Supreme Court rulings and the state constitution because it is not a uniform taxation on property.” The pro-taxers said they would appeal the decision to the State’s Supreme Court.

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