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Wednesday, September 27, 2006

The Inflation Tax

Congress is considering legislation to subtract out the inflation portion of capital gains prior to Taxation:

The old fight over indexing the basis for the capital gains tax is starting up again, and this is shaping up to be the best chance ever to finally end the unfair tax on inflationary gains. Legislation sponsored by Reps. Mike Pence of Indiana and Eric Cantor of Virginia, H.R. 6057, would use the Gross Domestic Product implicit price deflator to index the capital gains tax basis for inflation, ending one of the most egregious practices of our tax system. Perhaps more encouraging, it may be possible for the president to introduce indexing administratively, without the passage of any legislation.

The capital gains tax is currently applied to the difference between the sale price of an asset and its acquisition price, adjusting for any capital improvements, but not for inflation. Because there is no inflation adjustment, for a long-held asset, the capital gains tax is largely an inflation tax. When the government levies a tax on assets that have depreciated in real terms, it is actually confiscating assets, which is a violation of basic principles of fairness.

The article then goes on to describe lots of reasons why the inflation tax is bad and how it hurts the economy and I agree with that analysis.

Yet, I still think that getting rid of the inflation tax is a bad idea. While inflation is a monetary phenomena, I'm wondering if there are certain near crisis situations where an increased inflation rate coupled with the inflation tax may be beneficial. In a deep recession, where both the economy and government revenues are shrinking in real terms, increasing the rate of inflation to keep nominal GDP growth positive may enable a quicker recovery, basically by diluting existing debt, allowing continued government spending without raising income tax rates, and stimulating demand (since investment becomes less desirable in such an environment). In the early years of the Great Depression, this was not done and look what happened. In the 1970s, this was done (unwittingly), and though the stagflation was considered to be very bad thing for the economy, I have a snearking suspicion (unprovable) that the economy needed to go through a restructuring, and that part of the subsequent 25 years of high growth was partially enabled by the 1970s' stagflation. I realize that I'm about the only person on earth to think this, but I never let little things like that bother me.

The best way to keep the inflation tax low is to keep inflation at a manageable level. I think we should keep the inflation tax.


Howard said...

Some of your points may have validity, however, inflation does bad things to the effective tax rate on capital. Since indexing is an added complication, why not just have a cap.gains rate of "0" for assets held longer than 3 years for example. Shorter than that kind of timeframe only a severe inflation would matter.

Oroborous said...

But if we lower capital gains tax rates to zero, even with a three year holding period, then some people will evade taxes by structuring ordinary income to appear to be capital gains.

I would.

It's possible that the problem would be small enought that it shouldn't dissuade us from going to the zero rate.