Capital Gains tax adjusted for inflation?

Great Debates
1

One idea about capital gains that I have never heard of is the idea of adjusting it for inflation. (granted I am sure SOMEONE has brought it up, but I have never heard of it.) This would obviate the argument that one’s gains are being eaten up by inflation.

After capital gains are adjusted for inflation, they would then be taxed as normal income.

For instance, assume a 10% return on common equity (lets ignore dividends,) and a 3% inflation rate. After 5 years, a person in the (rounded) 40% bracket would pay around %25 on those gains. Normally they would pay %20. however, if they had only appreciated at 3%, same as inflation, they would pay NOTHING.

In addition, as a sop to the very rich or those cashing in a lot of equities at once, anything ABOVE, say, $10,000 or 90% or the total gains whichever is less could be deferred to another year. So someone with $20,000 in gains could defer $10,000, someone with $200,000 in gains could defer $180,000. This would be done to prevent peoples income brackets from rising too high when they cash out.

I think this system would increase the fairness in the tax system since it would encourage people to save by knowing that their gains would not be eroded. however, the one bad aspect I can think of would be that it would heavily increase the temptation for politicians to toy with the calculation of the inflation index.

2

It HAS been discussed it’s called “indexing”. Try “indexing capital gains” in google. The Brookings Institute on the subject, which may be more than most of us care to digest:

http://brookings.nap.edu/books/0815712707/html/119.html

The UK and Australia allow indexing. They also have extraordinarily high capital gains rates.

Most developed nations have lower capital gains rates than the US. Some, like Germany, have none. You should consider that when you hear a comparison of the upper bracket tax rates between countries.

3

Australia has just abolished indexation of capital gainsand has moved to a system of half-inclusion.

The standard tax economist’s prescription is for inflation adjustment, averaging and taxation on accrual rather than on realisation. It turns out that what you suggest is still concessional treatment of capital gains.

The problem with indexing is that you need to apply it to a lot more than capital gains. Interest payments on debt for example contain an inflation component. Typically tax systems allow this excessively generous deduction. Same for depreciation allowances. IIRC the US Treasury’s position (which IMHO is right) is that unless you are prepared to apply inflation adjustment across the board, it’s better not to do it all.