The Problem With Raising the Capital Gains Tax Now

OK, normally I stay away from posts that could be perceived as political.  But it’s hard to comment on economic issues in the heat of this intense primary season without venturing into those dangerous waters.

I’m going to try to be careful here not be too specific about any candidate or their plans.  I felt, however, that this topic was non-obvious enough that it was worth commenting on, despite the danger.  I can only hope that these comments might reach the ears of all three of the currently viable candidates…

Please don’t raise capital gains taxes in this environment

Or at least, please don’t raise them without also indexing gains to inflation.  It’s not a serious problem when inflation is extremely low for long periods of time, but it could be very very bad if we are, in fact, heading into an environment with a weak dollar and higher prices.

Why?  Because the capital gains tax today is based on nominal gains, not real gains.

Not clear on why this is a problem?  Here is an example:

Let’s say you bought a stock in 2009.  It’s a good stock, but not a great one, and it returns roughly 10% per year for the next 7 years.  In fact, by 2016 the stock has doubled, exactly, from $10 per share to $20 per share.  Since you bought 1000 shares, you’ve just turned $10,000 into $20,000, for a $10,000 gain.

That sounds good, and you might be thinking, “Well, with a $10,000, why should I begrudge the government $2,000 or even $2,800 of that gain?  After all, it’s this great country that has made that type of gain possible.”

Here’s the problem.  Let’s say inflation over the next 7 years is higher than it has been.  5% instead of 3%.  Well, then actually $10,000 in 2016 doesn’t buy what it did in 2009.  In fact, it takes over $14,000 2016 dollars to buy the same car that $10,000 did in 2009.

But the tax man doesn’t care.  The IRS still calculates your gain as $10,000, not $6,000.  So $2,800 might be 28% of your nominal gain, but it’s 47% of your real return, after inflation.

Ouch.

It gets worse.  If inflation manages to soar to around 8%, which it did in the 1970s, then actually that $2,800 tax becomes more than your entire real return.  At 8.1%, in fact, your real return becomes negative – you end up paying a real tax of over 100% of your inflation-adjusted gains.

Double-Ouch.

That’s pretty much what happened to people in the 1970s.  And it really did have a drastically negative effect on capital investment and tax collection, because rich people basically decided to either avoid capital investments, or they decided to postpone taking gains.  (Little known fact, but capital gain tax revenue has increased since we lowered the rate to 15%… a combination of better market performance and likely some acceleration of people taking gains.)

Now, in the 1980s and 1990s, this wasn’t such a big deal, because we both lowered capital gains tax rates and we killed inflation.  Or, at least, we wounded it.  When inflation is low, and the holding periods are relatively short (under 10 years), you could argue that the inflation “tax” automatically adjusts the 15% up to something higher, but manageable.

So, I think that leaves us in a policy bind, since it’s very likely we’re headed for higher inflation in the next 10 years.  In fact, you could argue that cutting the capital gains tax commensurate with the increase in inflation and the average holding period might make sense, if the goal was economic neutrality.

One solution would be to index capital gains for inflation.  It’s a sticky problem, because it means that taxpayers would have to have a table of “multipliers” to apply to any investment, based on the year of investment.  You would also likely have to exclude shorter holding periods to avoid trading scams, and have some sort of wash-sale like rule.  But this is all doable.

If you see another path around this problem, I’d love to hear it.  Right now, it feels like inflation is going to take a serious whack at capital investment if we’re not careful.

4 thoughts on “The Problem With Raising the Capital Gains Tax Now

  1. Excellent plain-English treatment of this problem Adam! I wish all of Congress understood this.
    Unfortunately our representatives and much of the public suffer from ‘step one’ thinking… they do not think beyond the first step in a solution. They think “we need more tax revenue” or “we need to tax the rich” and jump to “raise (capital gains) taxes as the answer. However, they do not think through the consequences of that action and what the outcome might be.
    The solution here is to NOT raise capital gains taxes or to lower them further, but populist and ‘stage one’ thinkers will never understand that.
    bravo,
    David

  2. There are many other issues with capital gains taxes.

    To some extent, the taxpayer can choose when to recognize the gain and pay the tax. So there will be a burst of tax revenues as people rejigger their portfolios, and then revenues will dry up as people wait for the rate to come down again. The burden of a higher rate will fall disproportionately on people who are pressed to make transactions (e.g. house sale due to divorce). Frequent changes – or even public argument about changing the rate – will reinforce this effect.

    Since estate tax rules reset basis and erase any capital gains, higher capital gains tax rates force the elderly to hang onto highly appreciated assets like homes and stocks. Death erases potential capital gains taxes.

    By locking up assets, capital gains taxes force misallocation of capital (elderly in large homes, capital in highly appreciated companies rather than start-ups) and they favor gifts of appreciated stocks to charities, rather than reinvestment by the shrewd investors who made the smart stock picks.

  3. I’ve been included in taxations for longer then I care to acknowledge, both on the individualized side (all my employed lifetime!!) and from a legal point of view since satisfying the bar and following up on tax law. I’ve provided a lot of advice and redressed a lot of wrongs, and I must say that what you’ve put up makes complete sense. Please persist in the good work – the more people know the better they’ll be outfitted to deal with the tax man, and that’s what it’s all about.

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