Shouldn't We Tax Real Gains, Rather than Nominal?

Great Debates
1

One of the reasons to have a lower capital gains tax than income tax is that some portion of capital gains isn’t real gains at all, but simply due to inflation.

Of course, having a constant lower rate isn’t as equitable as just taxing the actual gain in the first place. Someone who made just barely over inflation might end up taking an actual loss due to taxes, while someone who made significantly more than inflation will profit disproportionately. In effect, this promotes increased risk, since you end up better off with higher variance in your investments.

Why tax nominal gains over real gains?

Pros:

  1. A winning investment won’t ever be turned into a loss by taxation alone. If you eke out only a small real gain, you’ll still get some percentage of that gain (depending on what the rates are set at).

  2. Removal of tax code incentives to increase risk.

  3. Possible removal of “special treatment” assets like housing that tend to be held for long periods and don’t gain much anyway.

  4. As a society, we should focus more effort on real gains than nominal ones. It’s sort of silly to spend as much time and energy as we do on comparing nominal ones over large periods of time.

I admit that #4 is kind of a pipe-dream, but it’s one of those things that flares up in my mind whenever someone points out how their g’g’g’grandparents bought a little shack for $20 and a loaf of bread in 1876, and it’s worth over a million dollars now, or we see (used to see, I suppose) constant news stories about stock indexes reaching new records, when in real terms they’ve been fairly flat for quite a while. The real gain here is that we’d drain fewer tax dollars from people who make more conservative investments.

Cons:

  1. It would make taxes more complicated.

  2. There’s no good measure of inflation to use.

1 is true, but when has that ever stopped a tax-code change. This would only add one more column to the capital gains worksheet, and a pretty small percentage of taxpayers actually have to bother with capital gains anyway, right? The IRS could just publish average inflation numbers

2 is more pressing, but I contend that, with all its problems, using the CPI would still be an improvement over the nothing we’re using now. It’s fairly well-accepted and its limitations are well-known.

2

Market interest rates (i.e. rates of return) include an inflation premium in their pricing. Your gripe is with a failed and/or improperly priced investment, not the fact that the IRS chooses to properly tax investments.

3

They have an expected inflation premium, which may or may not end up tracking actual inflation. When it doesn’t, we end up taxing people on “earnings” that don’t really exist.

Or, to put it another way: why should every investment include inflation risk? Why not make that risk orthogonal to other investments, and anyone who actually wants to invest with inflation risk can buy instruments specifically for that purpose?

4

Of course these earnings exist - they just don’t buy as much as you thought/bet/estimated/guessed they would have. Because of your faulty expectations of inflation.

The government has to fund itself with real dollars by the by.