Lawmakers Should End the Inflation Tax

As inflation runs rampant, the inflation tax on capital gains has become a growing problem.

Lawmakers should end the taxation of inflationary gains in order to make the tax code fairer and fuel economic growth. Not only would this help middle-class taxpayers across the country, it could even provide an increase in government revenues.

What is the inflation tax?  

When a taxpayer sells a capital asset, they pay taxes on their gains-the difference between the basis and the sale price. Under current rules, Treasury determines the basis by looking at the purchase price of the asset at the time of purchase without consideration of the inflation-adjusted cost of the asset in today’s dollars. 

Over the years, other provisions in the tax code have been reformed to account for inflation such as income tax brackets, the standard deduction, and the Earned Income Tax Credit. This tax year, there were 62 tax provisions adjusted for inflation.

Not treating capital gains this way unfairly exposes taxpayers to additional taxation. For example, an investor makes a capital investment of $1,000 in 2000 and sells that investment for $2,000 in 2021 will be taxed for a $1,000 gain at a top capital gains tax rate of 23.8 percent. After adjusting for inflation, the “true gain” is much lower – just $352. (1,000 in 2000 – $1,648 in 2021).

Americans are taxed on illusory income as the result of economy-wide price-level increases, being punished for the existence of inflation. This problem is exacerbated by the fact that inflation has surged to a 40-year high of 7.9 percent. 

Ending the inflation tax would fuel our struggling economy.  

Capital gains taxes create double taxation on corporate income as it is an additional layer of tax on business income. First, businesses pay the corporate income tax on their earnings. Second, the investor pays the capital gains tax on dividends received or stocks when they are sold. This double taxation discourages savings, suppresses productivity, and discourages investment. It acts as a barrier to job creation, wage growth, and economic growth.

Lowering the capital gains rate would encourage the formation of more capital and would result in the creation of more jobs. In turn, worker productivity and wages would be higher. As we recover from pandemic shutdowns and supply chain issues, this would be especially helpful.  

Indexation would free up “sticky capital”—buildings, land, stocks—that are held by individuals or businesses rather than sold and put to higher and better use because much of the “capital gain” they’ve incurred is actually inflation and the high capital gains tax discourages mobility of capital. The value of all property in America would increase. 

Despite Democrats’ claims, indexing capital gains would help middle-class families.  

Democrats allege that this is another tax cut for “the rich” following enactment of the Tax Cuts and Jobs Act. 

At worst, indexing capital gains would reduce the share of the federal tax burden of the rich by a very minor amount. Democrats say that indexing capital gains would benefit the rich citing the Penn-Wharton Budget Model which said that 86 percent of the benefits follow to the top 1 percent of taxpayers. 

However, that same study shows that the top 0.1 percent see their share of federal tax burden drop from 13.6 percent to just 13.5 percent and the 99 percent to 99.9 percent percentile see their share drop from 15 percent to 14.9 percent.  In that context, it’s hardly a giant tax cut for the rich.  

ATR looked at Internal Revenue Service data from 2019 (the most recent available data) to determine what percentage of middle-class households had a capital gains filing: 

• 25,749,950 American households had a capital gains filing. 
• 13,046,720 (51%) made less than $100k 
• 20,077,260 (78%) made less than $200k 

As noted above, indexing the capital gains tax is would also promote investment and productivity, which helps millions of low- and middle-income workers across the country.

Reducing the tax on capital gains could actually increase revenues.  

Not only would it help the economy, but indexing capital gains could increase short-term revenues based on recent history. Each time the capital gains tax has been reduced it has created an unlocking effect, where pent-up gains that had built up over time are realized at greater rates than they would be if the tax was not changed. 

When tax rates are high, investors realize fewer gains. Conversely, when tax rates are lowered, investors realize their gains. In turn, this tax reduction triggers increased revenue to the federal government. 

For example, capital gains tax cuts in 1997 and 2003 saw higher than projected revenues as noted in this document:  

• In 1997, Congress cut the capital gains tax rate from 28 to 20 percent. Revenue estimators expected to collect $285 billion of capital gains tax revenue for fiscal years 1997-2000. However, tax revenues came in at $374 billion, 31 percent higher than revenue estimators suggested.
  
• As part of a larger tax bill in 2003, the capital gains tax rate was reduced from 20 to 15 percent. In 2003, JCT/CBO anticipated the government would collect $327 billion of capital gains tax revenue over the 5-year capital gains tax cut. However, the government collected $537 billion. 

Indexing capital gains used to be bipartisan.  

While Democrats claim this policy is a simple giveaway to the rich, it used to be considered commonsense.  

In 1992,  then-congressman Chuck Schumer (D-NY) urged an end to the inflation tax on capital gains. On the House floor, Schumer said: 

“If we really want to increase growth, there are proposals that we can do. I would be for indexing all capital gains, savings, and borrowings, and that indeed we shift the balance in this country from too much consumption, too much borrowing and toward more savings and investment over the long run.” 

Congressman Steny Hoyer (D-Md.), now the House Majority Leader, also endorsed indexing capital gains to inflation:  

“The capital gains provisions in H.R. 4287 benefit small business by indexing newly purchased assets. Income gauged would be much more reliable so that, real not inflationary gains will be taxed, and taxed at the same 28 percent maximum rate on gains.” 

There is strong support from conservatives for ending the inflation tax. Senator Ted Cruz (R-Texas) and Rep. Warren Davidson (R-Ohio) introduced the Capital Gains Inflation Relief Act, a bill that would index many assets to inflation to protect taxpayers from paying taxes on inflationary gains.  introduced the same bill in the House of Representatives.  

Senator Cruz’s bill is supported by Sens. Thom Tillis (R-N.C.), Mike Braun (R-Ind.), John Barrasso (R-Wyo.), Pat Toomey (R-Pa.), Jim Inhofe (R-Okla.), and James Lankford (R-Okla.).  

The federal government should end its practice of taxing phantom gains. Ending the inflation tax would make the tax code fairer, promote strong economic growth, and help middle class families.