Friday, January 4, 2008

Inflation and Capital Gains Tax

In The Deflation Monster, Wanniski says "Inflation can push real capital-gains tax rates above 100 percent on long-held assets, as the tax shifts from real gains to spurious inflationary increases in valuation." What does he mean by this and how is it possible to pay more than 100% on long-held assets.

Let's take a simple scenario.

Tom buys some asset for $100,000. Let's say the banks are causing inflation of 5% per year and that this asset perfectly retains its value from year to year. In other words, its real fundamental value never changes. It's worth the same to everybody today and 10 years from now. Because of inflation in the money supply, the nominal price of this asset increases every year to account for the inflation. One can make a simple series for this:

0 $100,000
1 $105,000
2 $110,250
3 $115,763
4 $121,551
5 $127,628
6 $134,010
7 $140,710
8 $147,746
9 $155,133
10 $162,889

So in year 10, the nominal price is $162,889. Tom decides to sell this asset. His real gain is zero because the asset has not appreciated in real terms. It's only appreciated in nominal terms. But taxes are on nominal gains. So Tom owes a tax on a capital gains of $62,889. At the 20% rate (and it used to be much higher), he'll pay $11,026 to the IRS. Tom just paid taxes on a real gain of zero.

Imagine that this asset was Tom's house and Tom wanted to move to a different neighborhood. He would have to buy a smaller house because of the tax on the nominal gain. Tom would need to take this tax consequence into account when making an unrelated decision. This creates an inefficiency. Now in reality, the Federal government realizes this would be unfair so it excludes the first $250,000 of profit from capital gains when it's on a house. But only when it's on a house and only the first $250,000 of profit.

If instead of a house, Tom bought a stock that paid dividends and its appreciation was due soley to nominal inflation, Tom would pay taxes on the nominal gains. He would then lose money on the stock. If after 10 years, Tom thought some other stock was a better investment, he would have to consider the tax consequence of selling the stock to buy the other stock. This makes the capital markets less efficient because the tax consequences can outweigh the gain by allocating capital to the most productive companies.

Now imagine Tom is really a wealth management fund for some wealthy investors. They have owned Exxon-Mobil for many years. They want to invest in some new solar technology because they think that's where the future is at for energy production. Unfortunately, they don't allocate their capital efficiently because of these tax consequences. So the solar company doesn't get as much capital as it could otherwise.

1 comment:

Eugene said...

Jon,
Very good point on how the government takes taxes on inflationary gains. The housing cap gains tax rate is 500K for married couples every 2 years, which isn't bad. However, your other asset example is right on, proves how strong the RE lobby is in DC.

On another note about taxes, I like the fair tax from an efficiency perspective (save all that time from filing and get rid of the IRS, also getting rid of expensive tax accountants) but not sure how "fair" it really is the middle class. It would elimiate a lot of dead weight loss from the current system if they can find a way to make it work.

Too bad the accounting firms and their lobbyists would crush any proposal like this...