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Friday, January 13, 2012

The Right Way to Tax Capital Gains

If I buy something, and sell it later for more than I paid, I have made a capital gain.  If I waited less than a year before I sold it, my profit is taxed like any other income.  The capital gain is added to my other sources of income.  But if I wait a year or more before I sell, then our current tax code treats it differently.  It's considered a "long term" capital gain, and the tax will be 15%.

So what's wrong with that system?  The most common complaint that one hears is that people who earn their living via long term capital gains are getting a tax break that is unfair to regular people.  Those who think this way say that all capital gains should be taxed the same as ordinary income.  But there is another issue that is talked about much less often, and that is the effect of inflation.  Inflation can produce long term capital gains that are totally illusory.  Suppose, for an example, that I bought a house in 1991 for $100,000.  then in 2011 I sold it for $200,000.  It seems like I earned $100,000, right?  But I didn't really, because the 2011 dollars are each worth less than the 1991 dollars.  According to the Bureau of Labor Statistics the $100,000 that I paid in 1991 has the same purchasing power as $166,100 in 2011.   If I had sold the house for $166,100 I would have broken even, or exactly gotten my money back.  Since I sold it for $200,00, my true profit is $33,900.  But I will have to pay tax as if the profit were $100,000.  My tax will be $15,000, which is almost 50% of my true profit.

So it seems that the current system is capable of taxing both too little and too much depending on the circumstances.  My proposal to remedy this is to take inflation into account when computing capital gains. The government already considers inflation for other purposes.  For example, social security checks are adjusted upward annually to compensate for inflation.  And the government sells a type of bond, Treasury Inflation-Protected Securities, or TIPS, whose value is adjusted for inflation.  Hence there is already a precedent for considering inflation in government financial matters.  So what I suggest is that capital gains be inflation adjusted by the change in the CPI from the time of purchase to the time of sale.  The distinction between long and short term capital gains is no longer necessary; it could be eliminated.  All capital gains could be taxed as ordinary income, but they would be computed differently.  The effect of this difference in computation would be to reduce the tax on long term capital gains, but the amount of reduction would depend on how much inflation occurred during the interval between purchase and sale.

My main point here is that capital gains should be adjusted for inflation.  Whether to tax them at the same rate as ordinary income, or to treat them differently, is another issue.  Since new business formation is aided by readily available capital, there is justification for giving favorable tax treatment to long term capital gains.  If this is done I think the waiting period should be something like 3 to 5 years, not 1 as is currently the case.  The latter encourages "flipping", which is not something to be encouraged.  5 years is a reasonable time to wait when you invest in a new business.

1 comment:

  1. An excellent way of explaining the issue of long term capital gains. I DO agree that an inflation adjustment is long overdue.


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