Indexing Capital Gains for Inflation

Follow the link for a great article by Richard Bahn of the Cato Institute called “Inflation and the Tax Man”

The fact that capital gains are not indexed for inflation has always irritated me. Now that Rudi Giuliani (who I’m not necessarily in favor of) has made this part of his tax proposals, the idea has gotten a lot more press. Here’s an excerpt from the article:

Assume you purchased a common stock in a company in 1984 for $100 a share and sold it in 2007 for $200 a share. Have you received any “income” from the sale of the shares of stock? The IRS would say “yes,” but this is clearly wrong. The IRS will claim that you had a $100 per share capital gain on the stock in the above example, yet actually the increase was solely a result of inflation. Because you cannot buy more goods and services with $200 now than you could have with $100 in 1984, you have had no “income” or wealth accretion.

The debate centers on the definition of income. The 16th Amendment to the Constitution states, “The Congress shall have the power to lay and collect taxes on incomes,” and the Fifth Amendment clearly states, “No person shall . . . be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use without just compensation.”

If the portion of a capital gain due solely to inflation is not income, then taxation without inflation-indexing is an unconstitutional taking of property. Income is commonly defined as, “the amount of money or its equivalent received during a period of time in exchange for labor or services from the sale of goods or property, or as profit from financial investments.”

It is not likely that many judges or members of Congress would find it in their personal, political, or the national interest to argue that phantom gains are “income.” After all, most Americans do understand the meaning of income, even if some in Washington do not.

This would make for an interesting Supreme Court case.  Chances are, the only way the IRS would find out you were indexing your capital gains for inflation is if you told them in a note on your return.  I could be mistaken but I don’t think Schedule D audits are very common…  after a few years, nobody has any idea what their basis is in anything.

3 Responses to Indexing Capital Gains for Inflation

  1. dave says:

    This is by far the most ridiculous argument ever made. Do rich people really need to get richer?

    The better question is why in our tax system do we reward capital more than work? Are we trying to say that we would prefer you to be rich and lazy, instead of middle of the road and hard working? As your post is about indexing capital gains I won’t get into how ridiculous the tax system is, instead I will easily refute this idea.

    All gains are inflated. Not just capital gains. Interest income by the very financial definition is nothing more than a inflation. So if you are a risk adverse saver and keep your money in treasuries rather than stocks you will get an average return of 3-5%, presuming you are in a 30% tax bracket your return is diminished to 2-3.5%. Long term inflation is 2-3.5% so therefore you have not made any money, just beat inflation.

    As a libertarian you should be grossly against indexing capital gains. Think about it, the free market already prices inflation into stock price. By indexing inflation you have now corrupted the free market inputs into the price of the stock and artificially changed returns.

    Additionally should our incomes be adjusted for inflation? Well I got a 2% raise but inflation was 3% so…….. exactly it’s ludicrous. Some of these financial reporters are without question some of the biggest morons out there. Richard Brahn needs to give his head a shake.

    So very simply the question is what I started with; As a society do we value capital more than work and ingenuity so much so that we are willing to make it completely unfair?

  2. Will says:

    Dave — your arguments are ridiculous!

    This has nothing to do with your socialist ideals of maximum wealth distribution through tax policy. This has to do with the Constitution.

    The 16th Amendment to the Constitution allows the Federal Government to collect income taxes:
    “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration”

    In Commissioner v. Glenshaw Glass Co. the Supreme Court defined income as “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion”

    The widely accepted interpretation of this decision is that, to be considered income, “wealth” has to have been created. In other words, you have to have made some money!

    If we stick to these guidelines which are based on the LAW, it is quite clear that realized capital gains derived solely from inflation do not meet the definition of income laid out by the Supreme Court. The 16th Amendment allows the government to tax income, not wealth.

  3. Will says:

    It is not necessary to index interest, dividends or wages for inflation.

    You say that “Interest income by the very financial defintion is nothing more than an inflation.” This is not entirely true. If you believed that, then you would have to assume that the Federal Reserve is attempting to have real interest rates permanently pegged at zero. Fact is, interest rates (lets use the 10-year as our defintion here) reflect both inflation, and the “cost of money.” For me to loan you money, you have to pay a rate of interest which incentivizes me to loan you the money, given all the other things I could do with it. If interest rates only reflect the rate of inflation, I’d be a fool to lend the money!

    You are right that interest rates are “grossed up” due to inflation. If you assumed zero inflation, the 10-yr would probably yield only 1%. So, without the inflation, your income from owning the bonds would be way less. The fact that you have to pay tax on the inflation part is kind of a wash…. without the inflation you wouldn’t have had the income in the first place.

    Interest, Dividends & Wages meet the definition of income as defined by the Supreme Court.

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