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1 John Aldridge & Kyle Pomerleau, Inflation Can Cause an Infinite Effective Tax Rate on Capital Gains 1 (2013)

handle is hein.taxfoundation/taxfaaga0001 and id is 1 raw text is: TAXS Fiscal Fact FOUNDATION December 17, 2013 No. 406 Inflation Can Cause an Infinite Effective Tax Rate on Capital Gains By John Aldridge & Kyle Pomerleau Introduction The United States' federal top capital gains tax rate is now 23.8 percent due to two tax increases at the start of 2013.1 This is problematic, because the capital gains tax creates a bias against savings, slows economic growth, and places a double-tax on corporate profits. 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. Under the federal tax code, the increase in an asset's price is determined as the nominal amount (i.e., not adjusted for inflation). When an asset (often a stock) is sold above its purchase price, a gain is realized and is taxed. 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. 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. 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. 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. The S&P 500 Since 1950 Over the past sixty years, the stock market has grown immensely in nominal terms. Figure 1 shows the nominal and inflation-adjusted value of the S&P 500 index from 1950 to 2013.2 In nominal terms, the S&P 500 grew from $18.43 in 1950 to $1,601.15 in 2013, an increase of 8,587 percent. Most of the growth of the S&P 500 happened in the 1990s when the value of the index grew from $332.68 in 1990 to $1,419.73 in 2000, a 327 percent increase. 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. What this means ' The top capital gains tax rate was increased from 15 percent to 20 percent on January 1, 2013 due to the passage of H.R. 8. An additional 3.8 percent net investment tax took effect on the same day in accordance with the Patient Protection and Affordable Care Act. 2 S&P 500 Historical Prices, YAHOO! FINANCE, http://finance.valhoo.com/qci/hps=%5EGSPC+Historical+Prices. ' The 2013 average is the value up to August 2013.

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