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In some instances, the practice of taxing the nominal gain can lead to an infinite effective rate on real capital gains when the increase in price is only due to inflation.
However, after adjusting the value of the S&P 500 for inflation, some of these nominal gains become real losses. When an individual buys a stock and later sells it for a capital gain, they must pay tax on this income. When stocks are bought at particular high points in the market, inflation can account for 100 percent of the capital gains tax owed.
Since inflation has been an ever-present phenomenon in the economy, it has affected the taxes owed on long-term capital gains every year since 1950. Taxpayers can end up paying a very high tax rate on capital gains and can even pay taxes on capital gains when the real value of their investment has actually declined. In order to stop the damaging practice of taxing individuals on inflation, one solution would be to repeal the capital gains tax altogether.
Repealing the capital gains tax would be a pro-growth change and produce positive long-term dynamic effects for the economy. Capital gains have historically been given a preferential rate over ordinary income, and there has been some discussion that this lower rate exists to account for the lack of inflation indexing. The capital gains tax is more damaging than other taxes because of the bias it creates towards consumption over savings and investment. The effective rate on real capital gains shown in Table 1 is the tax rate based on the actual tax owed on the nominal gain and the inflation indexed capital gain (or real capital gain).
Lunch Links: Tax Foundation Makes Dynamic Scoring Mainstream, DC Budget Autonomy, Tampon Exemption Today is May 26, the anniversary of the Quill v. Although these problems with the capital gains tax are well known, there is a more subtle issue with the tax that makes it even worse for taxpayers than these conventional concerns suggest. When an asset (often a stock) is sold above its purchase price, a gain is realized and is taxed. In fact, if a taxpayer purchased an average stock in 1999, 2000, or 2007 and sold in 2013, they would be taxed entirely on inflation.

In fact, the inflationary increase in price can cause a nominal capital gain for a taxpayer despite suffering a capital loss in real terms. As a result, the effective rate on real capital gains has exceeded the statutory rate every year since 1950. In an ideal world we would eliminate both the capital gain tax and the dividend tax as they create double taxation.
A decrease in the cost of capital would increase the amount of capital available for investment, improving the productivity of business and raising average wages.
There is already an excess of rules with regard to determining the correct basis and sales price in addition to the types of assets and transactions to which the tax applies. By applying the tax on a nominal basis, many further detrimental effects are caused, including an average effective rate on real capital gains that exceeds the top personal income tax rate, despite the preferential statutory rate capital gains receive. Entin, Case Study #3: Reduced Tax Rates on Capital Gains and Qualified Dividends, Tax Foundation Fiscal Fact No. In addition to the federal estate tax of 40 percent (which is fourth highest in the OECD), many U.S.
Any capital gain due to inflation is not accounted for, and the taxpayer is taxed on both their increase in income and on increases in prices economy-wide. In the 2000s, the market became volatile, crashing from a record high twice, though it still nominally grew to its highest point in history in 2013.
However, since there was inflation during this period, the real gain was actually only $78.79. Figure 4 shows the effective rates for stock purchases between 1950 and 2012 compared to the top statutory rate of 23.8 percent.
While keeping the current tax on capital gains in place, taxpayers could be able to index the basis of their gain to inflation.
The motives behind lower rates on capital gains are separate from the impact of inflation on the tax.
In certain situations, taxpayers face an infinite rate on real capital gains when the tax is solely due to inflation. Inflation indexing the value of the average stock gives the stock price in today’s dollars and, from that, the inflation indexed capital gain of $20.23 (column E).

An additional 3.8 percent net investment tax took effect on the same day in accordance with the Patient Protection and Affordable Care Act. As a result, the effective tax rate on the real (inflation indexed) capital gain has exceeded the statutory rate every year since 1950 and has averaged around 42 percent. What this means is that if an individual purchased an average stock any year between 1950 and 2012 and sold it in 2013, they would realize a nominal capital gain. The tax paid on inflation as a percent of a taxpayer’s total tax bill is relatively small if the stock were bought in the 1950s or in the 1980s due to the real increase in the value of the market since those decades.
The effective rate on real gains varied between 26.4 percent for a stock purchased in 1950 and 309 percent for stocks purchased in 1998. In order to index the long-term capital gains tax, applicable inflation ratios stretching back several years would need to be determined annually (such as those shown in column D of Table 1 in the Appendix), so that the taxpayer could adjust the basis (purchase price) of the asset in order to compute their real capital gain.
Indexing would address the current disconnect between the tax levied and whether the taxpayer actually made a profit or loss.
Inflation indexing would also accentuate the periodic nature of the revenues from this tax,[15] which results from the business cycle, since there would be far fewer real capital gains than nominal capital gains during a recessionary period. While repealing this tax would be the preferable option, inflation indexing would be an improvement that would link the tax to real increases in income rather than increases in inflation.
For stocks purchased in 1999, 2000, and 2007, the nominal price of the stock increased while the real value declined.
This would not be so different from the inflation factor the IRS determines annually for calculating the increase in brackets, thresholds, and deductions for the personal income tax. The capital gains tax owed on the average stock bought during these years is solely due to inflation. The average effective rate on real gains from 1950 to 2012 was 42.5 percent,[11] nearly twice the statutory rate.

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