Imagine that in January 2021 you bought 100 shares of a company at $100 per share. Since then, the consumer price index, one of the standard measures of inflation, has risen by 11.74 percent. Coincidentally, the stock price has kept pace with the inflation rate, rising from $100 to $111.74. Your shares are now worth $11,174. Their value, adjusted for inflation, has stayed the same.
But the IRS doesn’t see it that way. If you sell today, you will get a capital gain of $1,174. The federal government will tax you on that whole gain. If you’re in the 15 percent bracket for capital gains income, you will pay $176 in capital gains taxes.
So you paid $176 on a phantom gain, which means that you lost money.
Whatever you think of capital gains taxes, basic fairness dictates that people who get capital gains should be taxed on the real gains, not the phantom gains.
This is from David R. Henderson, “End the Tax on Phantom Gains,” Institute for Policy Innovation, June 22, 2022.
READER COMMENTS
Garrett
Jun 25 2022 at 9:38am
Therefore high inflation reduces capital formation.
Jose Pablo
Jun 25 2022 at 11:00am
If your salary keeps pace with inflation (lucky you!) you are paying more taxes also in a phantom increase of your salary. Even worse if your salary grows but less than inflation you will pay more taxes on a smaller salary!
Are you suggesting that the government (or any of its agencies) should create a “real currency” that should serve, at least, to calculate tax bases and tax liabilities?
[For a worst example on the “phantom thing”: in Brazil during the 2000’s (at least) you could buy an asset in US$, sell the very same asset for half the initial price, again in US$, and still own the Brazilian government an awful amount of taxes … in Brazilian Reais, this time]
Jose Pablo
Jun 25 2022 at 11:16am
That’s just wrong “real math”, you would be paying the same amount of taxes on the same salary … my bad.
Chile created in the 60s the UF (“Unidad de Fomento”) a non-circulating currency adjusted for inflation. It was widely used as a reference for the value of assets. Not sure if taxes were calculated and liquidated in UF, though.
vince
Jun 25 2022 at 5:06pm
Why the exclusvie focus on capital gains? If you put that $10,000 in a CD and you were in the 32% bracket, you would be much worse off. And the CD had no chance of keeping up with inflation to begin with, in the current environment.
Jose Pablo
Jun 25 2022 at 5:45pm
“you would be much worse off.”
But that has nothing to do with the tax code. In an unexpected (like in “not already included in the interest rate”) inflation environment, this will happen to you with any security with nominal fixed returns.
On real terms you are paying less taxes on your CD returns because of inflation. Granted, you are getting fewer real returns, but this is not something the tax code can fix.
vince
Jun 25 2022 at 7:47pm
But it does relate to the tax code. If investment income were to be defined as increase purchasing power, interest would not be taxed until it exceeded the inflation rate. And of course a loss in purchasing power could be rolled over to offset future increase in purchasing power. That’s fairness.
Jose Pablo
Jun 27 2022 at 10:07am
“interest would not be taxed until it exceeded the inflation rate”
No, interest payments will still have some value on real terms and the taxes you would be paying on this interests will also be less in “real terms”.
You are right that the principal repayment, at the end of the holding period, would mean a loss in real terms. The calculations will be very complicated though since the loss would not depend on the inflation rate but on the difference between the ex-post inflation rate and the ex-ante inflation rate reflected in the interest rate of the bond.
vince
Jun 27 2022 at 11:00am
“interest payments will still have some value on real terms and the taxes you would be paying on this interests will also be less in “real terms”.”
How about an an example?
Jose Pablo
Jul 3 2022 at 10:07pm
Let’s imagine a $100 two year bond with a 5% coupon.
The nominal payments would be:
Year 1: $5
Year 2: $105
Let’s say inflation is 8%
The real payments would be:
Year 1: $4.63
Year 2: $90.02
So paying taxes on “real income” would result on a taxable return of $4.63 on year one and a lost of $9.98 on year 2.
Matthias
Jun 26 2022 at 4:22am
I have some sympathy with your views here. But it’s seems a bit simple minded.
It is clear that capital gains taxes are levied on the owner of the assets.
But it’s not at all clear what their economic incidence is. Ie who does actually end up paying for the tax in economic terms? Can capital owners effectively make the issuers of assets pay for capital gains tax?
I don’t know much about fairness. The government has to be financed somehow, and I don’t see why we income taxes would be ‘fairer’ than capital gains taxes, or even capital phantom gain taxes.
I’m just glad that in my adopted home of Singapore we don’t have any capital gains taxes. And when I invest abroad, eg in the US I still don’t have to pay capital gains taxes.
I suspect indexing capital gains to some measure of inflation might makes sense from some efficiency point of view? That way inflation, even expected inflation, would distort capital markets less.
But you’d have to make up the lost tax revenue somewhere?
vince
Jun 26 2022 at 1:17pm
“But you’d have to make up the lost tax revenue somewhere?”
One make-up could be spending reductions. HA HA HA!!!! When has that ever happened?
robc
Jun 26 2022 at 7:40pm
Single Land Tax is the only morally acceptable tax, IMO.
Thomas Lee Hutcheson
Jun 26 2022 at 9:29am
I agree as part of a more complete tax reform:
Tax the indexed capital gains as ordinary income (including no mark up on inheritance.)
Eliminate business income taxes (except as a way to tax the income of non-income tax-paying owners) and then tax dividends as ordinary income.
Raise the amount of “retirement” income that can be deferred to move the tax system closer to a consumption, not income tax.
Shift tax preference for charitable contributions from deductions to a partial tax credit at a rate less than the top marginal rate.
Adjust personal income tax rates to off-set the above changes and reduce the full employment deficit to near zero.
Shift financing of SS/Medicare/ACA/Medicaid/unemployment insurance from the wage tax to a VAT a rate to keep this component of taxes and expenditures at an approximate zero deficit.
Jose Pablo
Jun 27 2022 at 10:12am
“Tax the indexed capital gains as ordinary income”
Why? even after the “indexed” part the capital gain tax is a double taxation.
The “indexed” thing, only solve the unbeliable part that now there is a double taxation in a no-gain.
vince
Jun 27 2022 at 4:54pm
“even after the “indexed” part the capital gain tax is a double taxation.”
Hutcheson said eliminate business income tax. That would eliminate double taxation.
Jose Pablo
Jul 3 2022 at 10:10pm
No, that would eliminate the triple taxation. As far as the capital gains taxes remain (even if indexed) the double taxation would still be there.
vince
Jun 26 2022 at 1:15pm
Generally, economists support consumption taxes (eg sales tax) over an income tax. Another highly regarded tax is the Georgist land tax, which is a tax on land but not on real estate improvements. We’ve chosen an inferior tax system, just like we’ve chosen winner-take-all voting, an inferior voting system.
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