Why the capital gains tax rates should be indexed for inflation to avoid double-taxation.
What are the capital gains tax rates? The official answer is deceptively easy. The capital gains tax rates are 15% for long-term capital gains, and short-term capital gains (held less than a year) are taxed at the ordinary income tax rate as determined by your tax bracket. But the entire truth, is much harder to explain.
First of all, what is a capital gains tax?
A capital gains tax is a tax on capital gains, the profit realized on the sale of a non-inventory asset that was purchased at a cost amount that was lower than the amount realized on the sale. The most common capital gains are realized from the sale of stocks, bonds, precious metals and property.
I emphasized the words "profit realized" as this gets to the heart of the explanation. Determining profit realized is not as easy as one might think. For example:
If you bought stock for $100 and sell it for $120, you made a profit, or capital gain of $20, right? What could be more elementary?
Now let me add some additional facts. Let's say you bought that stock in 1950, and you sold it in 2010. Now what's your profit?
The answer is, you actually had a loss. A huge loss. Why? Because of inflation — the $100 you had in 1950 is now only worth $13.48. According to the inflation calculator, you would need your $100 worth of stock bought in 1950 to actually sell for $895.62 for you to break even. The net profit of $20 is totally illusory.
And yet, the government will tax you on your illusory "gain" of $20 at 15% ($3.00) even though you actually had a loss of $775.62 ($895.62 -120.00).
But inflation — no one can control that, right?
"Inflation is always and everywhere a monetary phenomenon." – Milton Freidman
Most people think inflation is something out of anyone's control…it is mysterious and uncertain. But the truth is rather that the Federal Reserve creates more dollars (which it is authorized by Congress to do). Then, when Congress spends those newly minted dollars, those new dollars dilute the value of the previous dollars already in existence. This is inflation.
A fair question to ask is, if this is true, why hasn't rampant inflation occurred in proportional to the new dollars just recently created? The answer is, those dollars have been spent by the federal government, but a significant amount of that money has found its way back to idleness. US Companies don't feel like spending them due to the uncertainty and are sitting on an estimated 5.1 trillion dollars of cash. So those dollars aren't competing for anything. Only once the economy turns around, however, and those dollars start entering circulation competing for scarce resources, then and only then will we see some significant rates of inflation.
Tyler Durden at Zerohedge has a stomach-curdling story about what one could argue is a criminal level of global inflation since 1913. Why 1913? 1913 is the year the 16th Amendment was ratified, but it was also the year that its Malachi-crunch twin of wealth destruction, the Federal Reserve Act appeared.
So how bad has been global inflation? This bad:
When you see these rates of increase, that is how much phony wealth has been increased. A phony wealth the IRS is all too happy to tax.
How double-taxation applies to capital gains
This was a point I recall being brought up by Rudy Giuliani in the 2008 presidential primary, and that is why he proposed indexing any capital gains for inflation.
The idea is that the government shouldn't be allowed to tax the same dollars twice. This is a concept called TOAD (Taxed-Once-Already-Dollars — seriously — it's what we learned in law school). But again, with the Fed diluting wealth and the IRS — once through inflation and the other through capital gains — this principle is violated again and again. So in our example above, no tax would be due unless the stock sold for over $895.62.
In truth, a law is not required, just a faithful interpretation of the Glenshaw Glass test for taxable income to have a legal basis to implement Giuliani's proposal. Because inflation creates only a phony accession to wealth, there is no need to go on to the remaining Glenshaw prongs of realization and dominion. Typically, though, it is not a good idea to rely on federal courts to limit federal powers of taxation. See Roberts v. the People of the United States National Federation of Independent Business v. Sebelius.
What can be done about it?
Realistically, probably nothing. Wealth-envy and economic illiteracy are cultivated in this country in quantities suitable for export. There's a video of Peter Schiff interviewing delegates inside the 2012 Democratic National Convention who see no issue or downside to banning corporate profits. They appear oblivious to the fact that pension funds — even union pension funds rely on corporate profits.
Most people are fine with the so-called "rich" being double-taxed. However, this is not to say the double-taxation of capital gains will not affect them eventually. The double-taxation begins to matter when they find out that stock they inherited form a grandparent or a property they are trying to sell is subject to the capital gains tax. So politically, it is a very devious law that it nearly difficult to defeat: As for most people, year-to-year, capital gains taxes does not concern them. But then, one year, when it does, they are a tiny minority who the majority is taught to despise, and they may not set enough money aside to pay, so they wind up looking for a solution to their problem.
I've researched this and I haven't found a case where someone brought such a challenge. I certainly would expect such a challenge to lose, as the federal court are loath to limit federal powers and routinely deem any such challenge frivolous.