It’s Time to Stop Taxing Inflation and Start Indexing Capital Gains

COMMENTARY Taxes

It’s Time to Stop Taxing Inflation and Start Indexing Capital Gains

Mar 10th, 2022 4 min read

Commentary By

Preston Brashers

Senior Policy Analyst, Tax Policy, Hermann Center

Joshua Loucks

Spring 2022 Member of the Young Leaders Program at The Heritage Foundation

Those that spend beyond their means usually end up impoverished. Those that save and invest grow richer. Oscar Wong / Getty Images

Key Takeaways

The way to a wealthier and more prosperous American society is to foster a dynamic economy that encourages individuals to invest and save.

The U.S. was once the premier place for business and investment and could be again, but Congress must reform the tax code to reduce the penalty on saving.

There’s little upside to raising the capital gains tax, as it would raise little, if any, additional tax revenue.

There’s a common, misguided notion in Washington that the strength of the U.S. economy lies in the American people’s willingness to spend.

Commentators have described consumption as the “engine of economic growth” in the United States. They say we need to stimulate demand for the economy to grow.

This wrongheaded emphasis on spending also manifests itself in a U.S. tax code that discourages savings and investment.

However, what’s true for individuals is also true for nations: Those that spend beyond their means usually end up impoverished. Those that save and invest grow richer.

The way to a wealthier and more prosperous American society is to foster a dynamic economy that encourages individuals to invest and save, rather than discouraging it.

The current tax system does the opposite, placing layers of additional taxes on those who invest rather than spend.

If Congress wants to stimulate lasting economic growth—instead of inflation—it should reduce or eliminate the many layers of double taxation on investment and saving, such as the corporate income tax, the death tax, and the capital gains tax.

One of the best places to start is by indexing capital gains for inflation.

This is especially important today, with inflation at its highest level in 40 years. High inflation multiplies the damaging effects of double taxation on investment. Since the tax code doesn’t index capital gains for inflation, investors can be slammed with taxes even on investments that prove unprofitable.

To illustrate, consider that at the current rate of inflation, prices in the economy will double in less than 10 years. So, if you buy an asset today for $10,000 and sell it for $20,000 after 10 years, you’d have the same purchasing power after the sale as you started with. Despite gaining no real wealth from your investment, you would still owe tax on the $10,000 “gain” through inflation.

By indexing capital gains for inflation, policymakers could ease the burden of inflation and rectify this unfair, anti-growth feature of our tax code.

The dynamism of the American economy relies on capital flowing freely between individuals who save and businesses that rely on that capital to invest, compete, and provide good jobs for their employees. Arbitrarily taxing investors more based on the level of inflation prevents that.

For decades, countries around the world have reduced taxes on savings and investment, while the United States has lagged behind. Even if the U.S. indexed for inflation, its level of capital gains taxation would remain high by international standards.

The average country in the Organization for Economic Cooperation and Development has a top marginal capital gains tax rate of 19.1%. Including the average state taxes and the net investment income tax, the top capital gains tax rate in the U.S. is 29.2%.

The U.S. was once the premier place for business and investment and could be again, but Congress must reform the tax code to reduce the penalty on saving.

The current tax code stifles economic growth and places hurdles in the way of Americans who want to save and make the best possible investment for their families’ futures. An example of this is the “lock-in effect,” wherein high capital gains taxes cause investors to hold assets longer than they otherwise would.

This lock-in effect happens in several ways.

First, capital gains are taxed only after individuals sell or transfer assets, so investors can defer taxes by holding them longer. (By its nature, taxing “unrealized” capital gains—that is, gains in the value of an asset before the asset is sold—means taxing people on income that they have not yet earned.)

Second, a higher capital gains tax rate applies to assets sold after less than a year. The higher tax rate on short-term capital gains encourages people to hold assets for at least 12 months to qualify for the lower rate.

Finally, the graduated rate structure of capital gains taxes discourages taxpayers from selling assets in years when they’re in the top tax bracket.

High inflation—if left unaccounted for in the tax code—will exacerbate these lock-in effects, delaying or preventing capital from flowing to companies offering the highest return on investment. That will starve startups and small businesses of the funding they need, leaving a less dynamic economy and fewer opportunities for American businesses and workers.

Instead of indexing capital gains, many on the left, including former President Barack Obama, support higher capital gains taxes “for purposes of fairness.”

There’s nothing fair, though, about double taxation or taxing “gains” in inflation.

Indeed, there’s little upside to raising the capital gains tax, as it would raise little, if any, additional tax revenue. Even before inflation accelerated last year, economists estimated that the U.S. capital gains tax rate was near or above the tax revenue-maximizing rate. Yet, the Biden administration floated a capital gains tax proposal last year that would have almost doubled the top long-term capital gains tax rate.

Even worse, an earlier version of the “Build Back Better” bill would have taxed unrealized capital gains, forcing individuals to pay tax before earning income on an asset. In addition to being most likely unconstitutional, it would devastate business owners whose wealth is primarily held in the value of their business.

Instead of letting the economy suffer in the name of “fairness,” it’s time for policymakers to remove government-imposed barriers holding America back.

Indexing capital gains for inflation would increase investment, protect Americans against inflation, boost growth, and build wealth for future generations.

This piece originally appeared in The Daily Signal